Why the Middle East Is Keeping Oil Traders, Politicians Awake at Night

For many without personal or religious ties to the Middle East, the region's permanent state of conflict has created a state of news fatigue: people often can't be bothered to read any more stories of renewed tensions, or missiles, or bombings. It feels too much like the "same old, same old" to get concerned.

Well, what is happening in the Middle East today is not the "same old" story. The Middle East's tenuous stability is under attack from three angles, and the barrage is turning longstanding Sunni-Shi'a and Muslim-Jewish balancing acts on their heads, resulting in upheaval and tension as broad and deep as it has ever been. The first is Iran's drive for nuclear weapons and its aggression toward all things Western, Jewish, and Sunni Muslim. The second is Syrian President Bashir al-Assad's continuing brutal crackdown on dissidents despite condemnation from a raft of countries; the country's descent into civil war is prompting Syria's allies to abandon a sinking ship. And the third is Egypt's election, which after the first round of balloting has two Islamist parties vying for top spot, setting the stage for a dramatic shift in the Arab world's most populous - and until now most Israeli-friendly - country.

For those who dream of world peace, the situation has moved way past disheartening to nigh on scary. And for anyone interested in the energy markets or hoping economic recoveries in America and Europe can help solve the world's suffocating debt problems, the outlook is dark and stormy because an unstable Middle East means expensive oil for the rest of the world.

Increasingly Isolated and Angry: Iran

Iran is an Islamist republic, which means a regime guided by Islam and headed by an ayatollah or supreme leader. Importantly, Iranians are predominantly Shi'a Muslim, as opposed to the Sunnis that make up 80 to 90% of the world's Muslim population. Shi'a and Sunni Muslims split in the year 632, when the death of Prophet Muhammad gave rise to a dispute over succession. Sectarian violence between Sunnis and Shiites (as followers of Shi'a Islam are known) has continued unabated since then, persisting today from Pakistan to Yemen and highlighted by today's horrific twin bombings in Afghanistan that killed at least 54 Shiites as they celebrated their most important religious day.

In the context of current events, here's what matters about Sunni-Shi'a discord. We broke it into point form because it's too damn complicated to contain in short prose.

  • As home to 40% of the world's Shiites, Iran feels the need to stand up for Shiites around the world.
  • Saudi Arabia is predominantly Sunni, discriminates against its Shi'a minority, and sent roughly 1,000 troops into Bahrain this spring to help the Sunni royal family of that country suppress its discontented and mostly Shiite citizens.
  • Because of the Sunni-Shi'a divide, Saudi Arabia and Iran do not get along at all. Same goes for Iran's relations with Bahrain, Yemen, Pakistan, and a long list of Sunni-dominated countries.
  • Syria is the mirror image of Bahrain: in Syria the Assad family - who are Shiites - rules over a population that is mostly Sunni. The alliance between the rulers of Iran and Syria is started with their Shi'a connection, then spread to a joint hatred for Israel and the West.
  • The West believes Iran is supporting Assad's violent crackdown in Syria.
  • The Arab League has suspended Syria, a move led by Saudi Arabia and supported by other Sunni Arab Gulf states.
  • The withdrawal of US troops from Iraq leaves more room for Iran and Saudi Arabia to intervene and wage a proxy war. The worst possible outcome would be to restore the Sunni-Shi'a infighting that nearly tore Iraq apart during the US occupation.
  • Aware that his country could again become a Sunni-Shi'a battleground, Iraqi President Nouri al-Maliki has refused to align with the growing Arab consensus to ostracize the Syrian regime. In early December he said the downfall of President Assad would invariably lead to civil war in Syria, which in turn would necessitate new alliances in the region - a hint that Iraq could join an Iranian-led alliance against the Arab world's Sunni states. Iraq's Sunni minority fought and lost a bloody insurgency in the aftermath of the US invasion.

In the context of all this came that report on November 8 from the International Atomic Energy Agency claiming it has credible evidence that Iran is still developing nuclear weapons. In 2007 the Agency determined Iran's nuclear program could complete a nuke in three to eight years. We are clearly within that time frame now. In response Western nations significantly tightened sanctions against Iran, though the sanctions stopped short of impeding Iran's oil exports. The challenge there is that Iran plays a very important role in the global oil scene.

Iran produced 4.3 million barrels of oil per day in 2010, which constitutes 5% of the world's oil production, and exported 2.3 million of those barrels. Top customers are Japan, China, India, and South Korea, but several European countries also rely on Iranian oil. Italy gets 18% of its oil from Iran; Spain buys 13% of its crude from Iran; and Greece has traditionally relied on Iran for 10% of its crude oil supplies, though imports have increased this year as other suppliers shunned it for fear it would default.

The EU is considering embargoing Iranian oil to push Iran into cancelling its nuclear program. It's a noble thought but immediately invites three questions. First, where would Europe find replacement crude? Russian Ural crude is of similar quality, but its price has already shot to a rare premium over Brent crude. Could the beleaguered countries of Europe afford that?

Second, would it even work? China is not going to stop buying Iranian oil, whether the EU and the US want it to or not. Saddam Hussein was able to withstand oil sanctions for years.

Third, and most important, how Iran would respond? Iran's role in the global oil machine is not limited to its exports. Along Iran's southern coast lies the Strait of Hormuz. Almost all of the oil produced in the Persian Gulf - we're talking 15.5 out of 16.6 million barrels of oil per day - has to transit the Strait of Hormuz to access international markets. It is the world's most important chokepoint for oil supplies.

Iran has said it will blockade the Strait if faced with an oil embargo. Now, instead of losing 2.3 million barrels of daily supply, the world loses 15.5 million. The price of oil would double immediately, on its way to $300 a barrel.

Always a country with few friends, Iran now finds itself increasingly isolated. The country's two traditional allies are Syria and the Lebanese Shi'a militia Hezbollah; together these three have long stood against Israeli and American aspirations in the Middle East. But Syria is a tad bit preoccupied at the moment and Hezbollah, ever the opportunist, appears to be realigning towards newly Islamist Egypt.

The take-home is this: the Arab Spring has reinvigorated Sunni-Shi'a discord across the Middle East. The region's raft of sectarian tinderboxes had been kept somewhat cool by alliances on each side that kept the other in check. Those alliances are now failing, and one consequence is an isolated, angry Iran ready to lash out if provoked.

Do not underestimate Iran. Given reason, an attack on Israel is possible and a stranglehold on 15.5 million barrels of daily oil supply is probable. Either would escalate rapidly into scenarios we would all rather not contemplate.

There Is No Easy Solution for Syria

The deaths of more than 4,000 people - largely at the hands of President Assad's forces - is an affront too large for even Syria's staunchest allies to ignore. Hamas is one of those allies, having used Syria as a base of operations for many years. Now rumors are swirling that Hamas is looking for new quarters.

It makes sense. Hamas fears that remaining linked to an increasingly isolated and discredited regime is a liability. Iran is likely pressuring Hamas to stay in Syria, but Hamas does not rely on Iranian support as much as it once did: Iran supplies less than 10% of Hamas' budget, mostly in the form of weapons. Since the fall of Muammar Gaddafi, however, a new stream of weaponry has become available from Libya. And ties between Hamas - a Sunni movement - and Shi'a Iran were never ideological but based solely on mutual enmity toward Israel.

It was a marriage of convenience, but for Hamas other options are emerging that hold more appeal. The most tantalizing is an alignment with the region's emerging powers, notably the Muslim Brotherhood in Egypt. The relationship is already forming: Cairo's acting military government played a significant role in reconciling Hamas with Palestinian rival Fatah and led negotiations to secure the release of thousands of prisoners in exchange for Israeli soldier Gilad Shalit.

Hamas is not the only ally looking for an exit. Turkey, which in recent years had grown very close to Syria, turned its back on its former friend last month, joining the long list of countries to impose sanctions and publicly denounce Assad's actions.

Not yet showing any signs of bowing to international pressure, over the weekend Syria put on a display of military might, staging a military exercise involving missiles, rockets, tanks, and helicopters that made headline news (on state-controlled media stations) across the country, even as the death toll continued to mount. Local coordination committees, which are the only source of information from inside Syria since foreign press are not permitted, claim 848 people were killed in October, including 59 children, making it the deadliest month since the uprising began.

If Bashar al-Assad's rule prevails, Syria will be a discontented Sunni population held in check by a Shi'a tyrant - not a stable scenario for Syria or the region. If he falls, Syria will descend into civil war between Sunnis and Shiites, a face-off too tantalizing for the region's other Sunni and Shi'a countries to ignore. Neither option would bring any stability to the Middle East.

Egypt's Choice: Islamist

It is not the outcome the West expected after cheering on the young Muslims who showed enormous courage in demonstrating for freedoms in the face of authoritarian repression in Tunisia, Morocco, Egypt, Syria, and Bahrain. When the first three countries on that list held relatively free elections, it was Islamist parties that prevailed.

Results from the first round of voting in Egypt indicate about 40% support for the Muslim Brotherhood's Freedom and Justice Party. The Brotherhood is the largest Islamic party in the Middle East, with branches and allies in many countries, including Hamas and Hezbollah. And in a more surprising turn of events, the Nour Party appears to have some 25% of the ballots at this point, a number that will likely rise as polling in rural Egypt gets under way. Nour candidates are Salafis, an ultra-conservative Islamist group.

The Brotherhood and the Nour do not like each other much, so odds are low they would form an Islamist coalition. More generally, there is no reason to think Egypt, Morocco, or Tunisia will become Islamic theocracies like Iran anytime soon. However, the success of Islamist parties proves that religion is still the most important ideology of all for these populations.

Egypt is the most populous and internationally influential country in the Arab world. This swing toward Islamic governance is highly significant, as it has the very real potential to turn Israel's most important Arab ally into yet another enemy. Egypt's Islamists generally oppose their country's 1979 peace treaty with Israel, though the Brotherhood has said it will respect the treaty while seeking modifications acceptable to both sides. At this point, Egypt cannot really afford to dishonor the treaty, as it has bought the country billions in US military assistance. Regardless, in time almost anything can change, and the new Egypt will certainly be less compliant to American demands, cooler to Israel, and warmer to Iran than was the old Egypt.

The Energy Implications

The world's oil markets are sensitive animals, prone to overreacting and slow to heal. Their herders, the oil traders, are best able to control their flocks when supplies are stable and predictable.

The Middle East is about as far away from stable and predictable as you can get right now. And since the Middle East is to oil as water is to fish, that means one simple thing: expensive oil. One word from an Iranian politician about the Strait of Hormuz would probably send futures up a percent in hours. The unexpected Nour victories in Egypt likely have oil traders lying awake at night, worst-case scenarios running through their heads. The world's foreign ministers are praying to their various gods that Sunnis and Shiites somehow miraculously find peace in Syria, because there is no apparent solution other than a miracle.

Expensive oil is more than annoying. With the US and the EU both facing unprecedented debt problems and struggling to breathe new life into stagnant economies, expensive oil could be the straw that breaks the camel's back and sends the world spiraling back into a recession... or worse. The world is at a precarious crossroads right now and a wrong turn could easily snowball into nationalist and sectarian violence compounded by global competition for scarce and shockingly expensive oil.

Maybe those who are fatigued by Middle Eastern strife have it right: maybe ignorance would be bliss. Such bliss would be fleeting, though, because the only way to ride out a storm is to understand what drives it.

[If you find this glance through the tangled web of politics, religion, and oil interesting, you need to see the December edition of Casey Energy Opportunities, which comes out next week. In it we delve far more deeply into Iran, looking into the history that brought it to this point, the options for how it could play out from here, and what it all means for energy investors. From now through December 16, you can get a year's subscription to Casey Energy Opportunities for free, simply by taking our precious metals advisory, BIG GOLD, for a risk-free trial.]

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