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Kass: The Next Black Swan

The price of gasoline is the most visible cost with which consumers deal. Most people drive by gas stations several times during the day. They watch news clips about higher gas prices on television and hear about it on the radio.

As I mentioned in my Barron's interview with Alan Abelson over the weekend, have you priced plane tickets recently? If you haven't, you will be surprised/shocked.

And look at the transportation index's recent swoon as a forward-looking tipoff of the possible demand impact of higher energy prices.

A tentative economic recovery is vulnerable to exogenous shocks, and higher gas prices might be one of the most conspicuous of those shocks.

Over the weekend, my buddy/pal/friend Cumberland Advisors' David Kotok sent me an email that provides an excellent history lesson and puts the oil price into perspective.

David has given me permission to summarize his email.

We thank BCA Research (March 1 special report) for compiling this list of oil/energy shock events. Every one of them led to a temporary spike in the oil price. I will add personal comments on the older items in the list, since many readers may be younger than I am. Note that in each case there was an oil-price spike, followed by some economic shock and then a period in which oil normalized to a supply/demand-balancing price.

November 1956 to March 1957 -- Suez Crisis. This marked the first time Egypt attacked Israel and was decisively rebuffed. Egyptian President Gamal Abdel Nasser triggered the event by nationalizing the Suez Canal, closing the canal and the Straits of Tiran to Israeli shipping, blockading the Gulf of Aqaba, and putting the Israelis in a "no other choice but war" condition. Britain and France reacted against Egypt. Israeli forces rebuffed the Egyptian army, crossed Sinai and reached the canal. Nasser had fought against Israel during its 1948 War of Independence. He had then led the overthrow of the previous Egyptian government in the early 1950s. He consolidated power in 1955 and 1956. Then he launched the attack.

Kotok comment: I remember the Suez crisis because it was a subject of intense discussion in my household. As a teenager in a community where many had family in the Middle East, it was impossible to avoid daily conversation and attention to the national news. Half a century later, I realize that the Middle East does not change much. Only the characters change. The story of strongman after strongman and war after war is an ongoing saga.

June-August 1967 -- Six-Day War. Israel was attacked on all sides and in a fight for survival. The result was a massive defeat for the attackers and the establishment of the Israeli armed forces as the dominant power in the region. Syrian, Egyptian and Jordanian forces were repelled. Jordan fought bravely but lost to the military superiority of Israel.

Kotok comment: Jordan's King Hussein changed his strategy after that war, which is why he did not participate in the next war against Israel. The Jordanian-Israeli nonbelligerency continues to this day. It gets strained at times, however, neither side wants war and both sides realize that war with each other is a losing proposition.

October 1973 to March 1974 -- Yom Kippur War and Arab Oil Embargo. On the possible advice of the U.S., Israel waited until it was attacked by Egypt and Syria. Jordan did not participate in the attack, and Israel did not attack Jordan. That allowed Israel to fight a two-front war instead of a three-front war. The attacking Egyptian and Syrian armies made a strategic blunder: They waited until the holiest day in the Jewish calendar to launch the war. Businesses were closed and families had gathered for the holiday, and that allowed rapid mobilization. Had the attack been on a midweek business day, the outcome could have been different. Israel again showed its determination when its back was to the wall and it had no choice but to fight.

Kotok comment: Iran may ignore history at its peril. Israeli leaders' patience is not a sign of weakness.

November 1978 to April 1979 -- Iranian Revolution. Jimmy Carter's presidency was undermined by the images of American hostages in Tehran. Oil and the Straits of Hormuz were the dominant themes.

Kotok comment: The late 1970s showed how monetary policy could be easy enough to allow an oil-price shock to morph into a broader and more vicious inflation. Oil gapped from $3 dollars a barrel to $12 a barrel in the Arab embargo period. It reached $30 a barrel at the peak in 1980. By 1979, inflation was headed to double digits. It took decisive action by new Fed Chairman Paul Volcker to attack it. Under Volcker (1980-1981), interest rates reached the highest levels in American history. Volcker broke the inflation cycle and started a 30-year disinflationary trend that has lasted until today. He positioned a platform for Fed Chairman Alan Greenspan to preside over 18 years of this trend. Ben Bernanke is the inheritor of that platform.

October 1980 to January 1981 -- Iran-Iraq War. Saddam Hussein showed his true colors. The enmity between Iran and Iraq continues to this day. Later in 1981, the Israeli air force destroyed the fledgling nuclear facility at Osirak, Iraq, weeks before it was to start operating. Years of Iraqi-focused diplomacy by the U.S. and the Western powers had failed. Israel again found itself with a no-choice decision.

The rest of this list is in the recent memory of most readers, so we will not add comments. Observations about oil and markets come after the list.

August 1990 to January 1991 -- Iraqi Invasion of Kuwait.

June-July 2001 -- Iraqi Oil Export Suspension.

December 2002 to March 2003 -- Venezuelan Strike.

March-December 2003 -- War in Iraq.

September 2005, Hurricanes Katrina and Rita.

BCA closed its list with this question about the future: "2012: Will there be 'closure of the Straits of Hormuz?'"

Take out the hurricanes and all the oil-price shocks have a common theme. There is a strongman. There is a shooting war or a threat of a shooting war. Diplomacy and sanctions and negotiation have failed. The final few days leading to the spike and the shock are impossible to forecast in advance. Probabilities of outcomes are meaningless. Tell me how anyone is to make a decision based on some geopolitical forecast of a 50-50 probability that Iran will mine the Straits of Hormuz. Or alternatively, a 50% chance Israel will attack Iran's nuclear facilities.

History also shows that oil prices have an upward trend during the period leading to the final spike. In every case, the peak in price only came after something was seen as a terminal event or final action. Subsequently, prices plummeted.
Doug Kass is the president of Seabreeze Partners Management Inc. Under no circumstances does this information represent a recommendation to buy, sell or hold any security.

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