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Tragedy -- and Retaliation -- to Strongly Affect Energy Sector

The terror that shook New York, Washington, D.C., and the nation is something none of us will soon forget. It is life-changing -- in both immediate and lasting ways that we don't yet completely understand.

In the next several days, as the immediate shock and trauma give way to the reality of a global clock that continues to tick, citizen-investors will again turn a portion of their focus to the financial markets. While it seems so inconsequential, the return to a daily routine may prove therapeutic -- an assurance that some sort of normalcy will eventually return to our communities and our world.

This act of terror has implications for the financial markets. Given the probability of U.S. retaliation focused on the Middle East, the ramifications on energy and energy investors are significant.

Retaliation: Higher Oil Prices Now...

In the tragedy's immediate aftermath, oil prices soared as traders braced for an immediate response. As it became clear that U.S. policy would be more deliberate, oil prices returned to near pre-attack levels. OPEC also pledged to keep oil flowing around the world.

However, analysts say prices are likely to soar if the U.S. unleashes a military assault on Middle Eastern targets that are likely harboring terrorists.

"If the U.S. reacts militarily, it will spike oil prices," says Marvin Zonis, a professor at the University of Chicago Graduate School of Business, who focuses on Middle Eastern affairs and has served as a consultant to the U.S. State Department and the National Security Council. "The action might not interrupt oil supplies, but traders would be very nervous."

Recent history supports Zonis' conclusion. The Persian Gulf War nearly doubled oil prices, which pushed $40 per barrel.

Many analysts expect history to repeat itself. "Judging by the experience of the Gulf War, we expect to see a significant movement in crude prices as tensions in the region will, no doubt, be escalated," says Marshall Adkins, director of energy research at Raymond James. "Clearly, there will likely be a short-term, knee-jerk reaction that drives both oil and gas prices sharply higher."

While OPEC has pledged to keep oil flowing, U.S. action in the Middle East could change its thinking. While Afghanistan is neither an OPEC member nor an oil producer, attacks closer to OPEC interests -- in Iran, Iraq or elsewhere -- could cause OPEC to reassess its policy.

"If the U.S. were to attack a country with oil interests, OPEC could change their position instantly," says Bryan Dutt, portfolio manager at Ironman Energy Capital. "OPEC politics and nation-state strategy are very fragile, especially in the Middle East."

A policy shift of that magnitude would push crude prices sharply higher. Fortunately, Zonis thinks OPEC is smart enough to know such a policy would be self-defeating.

"I do think the Arab countries understand that their interests do not lie with terrorists," Zonis says. "While their public positions may sound ambiguous, they will not side with Iran, Iraq or the Taliban government against the U.S."

... Lingering Effects Unclear

While retaliation may push oil prices sharply higher, the lingering effects of the terrorist attack may put downward pressure on energy prices.

"The economy is so close to being in the tank that this could very well push it over the line," says Zonis.

Again, recent history sheds some light here. "The Gulf War in 1990 no doubt contributed to sending the U.S. economy into recession," says Adkins. "The first World Trade Center bombing also clearly had a dampening effect on the economy."

He has a point. Just the direct commercial impact of the World Trade Center destruction will likely serve to dampen economic growth. A look at consumer spending data in 1993 shows a noticeable dip between February and March, the time of the Trade Center bombing.

Clearly, the catastrophe of that explosion pales in comparison to Tuesday's destruction and, combined with the likely lingering effects on consumer confidence, the impact of Tuesday's actions are more likely -- at least in the next several months -- to exacerbate the current slowdown in energy demand.

"There could be a tremendous decrease in energy demand," Zonis says. "The American people will get nervous. They will postpone consumption and investment, postpone purchases and postpone travel."

Walking the Line

As investors return to their posts Monday, awkwardness will set the tone. It will be difficult to regain a sense of purpose in such a tragic time.

Yet, the political and military events almost sure to follow will have a clear impact on the energy markets.

"When, as and if we do respond, there will be an energy reaction; stock prices will likely go up," says Tom Petrie, co-founder of Petrie Parkman & Co., a Denver energy investment firm.

However, any price surge would be an opportunity to lighten up on energy positions. "I also tell you I would sell into the rally," Petrie says. "History says whatever spikes you get are very short-lived. Typically, in the aftermath, demand craters, and you usually get lower lows."

Energy traders agree. Scott Walters of Research Capital in Toronto says the fundamentals of the markets don't justify higher prices. "If you see a global response and the potential for temporary disruption, you will see a knee-jerk rally and you sell it," he says. "Right now, the fundamentals of oil and gas suggest you should sell the stocks, especially if the economic impacts of this disaster are as we expect."

Disaster is an understatement, and this commentary in no way should diminish its magnitude. Every analyst I spoke to agrees.

Says Petrie, "This is evilness in the extreme."

Christopher S. Edmonds is president of Resource Dynamics, a private financial consulting firm based in Atlanta. At time of publication, neither Edmonds nor his firm held positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Edmonds cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send it to Chris Edmonds.

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