GLOBAL MACRO | IN DEPTH Perspectives on Iran, the Middle East, and Oil How can Middle East tensions impact oil prices, stocks, the economy, and presidential elections? We explore past crises, the recent tensions with Iran, and our outlook.

DEEPER ANALYSIS OF INVESTMENT TRENDS AND TOPICS

January 16 , 2020

John LaForge Key Insights Head of Real Asset Strategy » The Middle East produces a significant portion of the world’s oil, and geopolitical uncertainties in the region have a history of bringing volatility to oil prices. Austin Pickle, CFA Investment Strategy Analyst » While geopolitics involving the Middle East have become testy—to say the least—we have been anticipating this for some time (ever since the U.S. re-imposed oil sanctions

on Iran in 2018). » We expect tensions to remain high, and we believe that our 2020 oil-price year-end target midpoints of $60 per barrel for West Texas Intermediate (WTI) crude oil and $65 per barrel for Brent best balance supply, demand, and these geopolitical risks.

“Character and personal force are the only investments that are worth anything.” —Walt Whitman

While geopolitics involving the Middle East have become testy—to say the least—we have been anticipating this for some time. Tensions between the U.S. and Iran have been rising ever since President Trump began pressuring its trading allies to stop buying Iranian oil in 2018. Iranian oil exports have since plummeted (Chart 1), along with government revenues. As it was pushed into the proverbial corner, Iran lashed out in 2019 by attacking oil tankers in and around the Strait of Hormuz, and drone-bombing Saudi oil facilities. Over the past three weeks, the conflict intensified with the U.S. killing key Iranian military leaders—and Iran launching missiles at U.S.-occupied military bases. And here we are.

© 2020 Wells Fargo Investment Institute. All rights reserved. Page 1 of 10 Chart 1. Iran crude-oil exports by destinations 2500

2000

1500

1000 Thousandbarrels perday

500

0 2015 2016 2017 2018 2019 China India Europe Other

Sources: Bloomberg, Wells Fargo Investment Institute. Monthly data: July 31, 2015 – December 31, 2019.

Is the Middle East losing its sway over oil prices? Eastern politics. We disagree. Thirty-four percent is a Geopolitical uncertainties, especially in the Middle substantial share, and if the economic world wants to East, have a history of bringing volatility to oil prices. keep going around, we believe it needs OPEC’s oil. The reason is that the region controls a substantial With that being said, the slipping red line does suggest amount of oil resources. The red line in Chart 2 that OPEC is slowly losing its grip as the world’s highlights crude-oil production by the Organization of largest oil supplier. In 2006, OPEC’s share of world oil the Petroleum Exporting Countries (OPEC), which is production was 43%. largely composed of countries from the Middle East. OPEC is slowly losing its market share to the U.S. The As of last year, 34% of the world’s oil production came U.S. shale revolution has propelled the U.S. to the top from OPEC. of the oil-producing charts. The green line in Chart 2 Some say that the world does not need OPEC’s oil, and highlights that the U.S. now accounts for more than the West does not need to concern itself with Middle 20% of the world’s petroleum production. This number was less than 10% in 2006.

© 2020 Wells Fargo Investment Institute. All rights reserved. Page 2 of 10 Chart 2. U.S. and OPEC oil production versus global oil production 48 Global production (right scale) 105 OPEC production as % of global (left scale) U.S. production as % of global (left scale) 100 43

95 38 90

33 85

28 80

75 Million barrels per day

Oil production Oilglobal production of % 23

70 18 65

13 60

8 55 1980 1985 1990 1995 2000 2005 2010 2015

Sources: Energy Information Administration, Wells Fargo Investment Institute. Yearly data: 1980 – 2019.

Does Iran still matter to oil prices? We believe the other factor in play here, that makes Does Iran still matter to oil prices? After recent U.S. Iran relevant, is that many of the oil fields in the sanctions, Iran’s oil production has dropped from 4 Middle East are large, concentrated, and in close million barrels per day to 2 million barrels per day, proximity to Iran. We witnessed the relevance of this which is only 2% of world oil production. Yet, Iran over the weekend of September 14-15, 2019, when Iran continues to make global headlines daily. Controlling sent drones “next door” to destroy one of the world’s only 2% of world oil production makes it look like Iran largest oil-processing facilities in . That doesn’t matter. And President Trump says that Iran attack should be a reminder to investors that Iran, and does not matter. Yet, Iran continues to make headlines, the Middle East for that matter, can still hold great and persistent conflict tells us that this country does sway over global oil prices. matter to oil markets. Our take is that this is because

Middle Eastern oil still matters to global oil markets. Iran, even while it only produces 2 million barrels of oil per day, has proven politically adept at meddling inside the other OPEC-member countries.

© 2020 Wells Fargo Investment Institute. All rights reserved. Page 3 of 10 The history of Middle Eastern crises’ impact on Table 1 highlights average oil performance following oil prices 20 Middle East crisis events, since 1990. These events are shown in Chart 3. History suggests that when turmoil in the Middle East hits, investors should expect to see volatile oil prices.

Table 1. Average Brent crude performance around Middle East crisis events 1 month before 1 month after 3 months after -0.2% 4.5% 8.0% Sources: Ned Davis Research Group, Bloomberg, Wells Fargo Investment Institute. Please see end of report for list of crisis events.

Chart 3. Middle East crisis events and oil price Northern Mali conflict 160 Lebanon crisis Islamic unrest in Egypt Anbar clashes Israel and Lebanon Iraqi civil war bombings Iran drone strike 80 Al-Qamishli riots 40 Turkish coup attempt U.S.S. Cole bombing Gaddafi overthrown

Oil price (U.S. dollars per barrel) per dollars (U.S. Oilprice 20 begins War in Afghanistan Iraq uprisings South insurgency Bombing of Iraq Israel invades Gaza 10 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020

Sources: Bloomberg, Ned Davis Research Group, Wells Fargo Investment Institute. Daily data: January 1, 1990 - January 9, 2020. Oil prices are represented by the West Texas Intermediate Cushing crude spot price. Past performance is no guarantee of future results.

© 2020 Wells Fargo Investment Institute. All rights reserved. Page 4 of 10 Middle East crises’ impact on stock-market average, about three months, and then they fade as the performance peak risk to oil supply fades too. One point of note, though, is that these crisis events As for the impact on stock markets, we have found that historically have been short-term risks and not years- Middle East crises have had little lasting impact. The long threats to oil supply. As a result, oil price volatility blue line in Chart 4 represents the average has not tended to last very long on average. The performance of the S&P 500 Index. Notice that the U.S. vertical black dashed line in Chart 4 represents the stock market, typically, tends to shrug off turmoil in start of the 20 Middle East crises, since 1990. The the Middle East, even during the initial oil price spike orange line highlights the average oil performance (Chart 4, orange line). going into—and coming out of—Middle East crisis events. Notice that initial oil price spikes last, on

Chart 4. Performance of stocks and oil around Middle East crisis events 112

110

108

106

104 Indexed value 102

100

98 Average S&P 500 Index performance Average WTI oil performance

96 -90 -60 -30 0 30 60 90 120 150 180 210 240 270 300 330 360 Calendar days around start of crisis

Sources: Bloomberg, Ned Davis Research Group, Wells Fargo Investment Institute."0" indicates the start of the crisis. Indexed to 100 as of crisis date. Lines indicate the average performance of S&P 500 Index and West Texas Intermediate (WTI) oil price. Daily data: crisis events from 1990 to present. Please see end of report for list of crisis events. Past performance is not a guarantee of future results.

© 2020 Wells Fargo Investment Institute. All rights reserved. Page 5 of 10 To be clear—it is not that oil prices do not have an prices surpass this 30% (higher) level. In other words, impact on stock markets. They certainly can. The sustained spikes in the price of oil have been a impact is usually felt, however, when oil prices have headwind to stocks in the past. been trending higher over a longer period than three months. The performance box in Chart 5 highlights Consequently, investors worried about the impact of annualized S&P 500 performance after oil prices have oil prices should look to see whether the Middle East risen by 30% or more over a year’s time. Notice how crisis event is one with "legs" to it. annualized stock gains slow dramatically after oil

Chart 5. Stock performance versus oil performance Monthly Data: 01/31/1973 - 3200 S&P 500 Index

800 Index value 200

50 Stock performance when oil year-over-year rate of change is: Annualized return (%) % of time Above 30% 0.7 22.6 Between 0% and 30% 9.0 36.1 Below 0% 11.1 41.3 100% 80% 60% 40% 34.5% year - 20% over - 0%

Year -20% -40% -60% Oil price year-over-year -80%

1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 Sources: Bloomberg, Bureau of Labor Statistics, Wells Fargo Investment Institute. Monthly data: January 31, 1973 - December 31, 2019. Oil prices from 1951 to April 1983 are Bloomberg Arabian Gulf Arab light crude spot prices, and prices from May 1983 to current are West Texas Intermediate Cushing crude spot price.

© 2020 Wells Fargo Investment Institute. All rights reserved. Page 6 of 10 Economic impact of oil-price spikes gross domestic product (GDP) growth, shown in Chart Not each Middle East crisis has been the same, of 6. Currently, the average U.S. retail gasoline price is course. Some have had larger impacts on oil prices $2.58, so we feel the U.S. economy looks to be in the than others. For those that have led to significant oil- clear for now. For U.S. GDP to slow somewhat, we price spikes, there typically has been a corresponding anticipate today’s gasoline prices would need to rise by economic impact. Historically a gasoline price of $3.00 an additional 15% to get to the $3.00 level. This would per gallon is the past level that has led to slower U.S. equate, roughly, to a $70 per barrel WTI crude-oil price. WTI trades around $60 per barrel today.

Chart 6. Real GDP versus real gasoline prices

10% Real GDP (year-over-year) 8% 6% 4% year) - 2% over - Real GDP 0% (year -2% -4% -6% Annualized GDP growth rate Real GDP growth when real gas price is: % of time (%) Above $3 2.11 31.03 $2 - $3 2.94 52.87 Below $2 3.34 16.09 4.7 Regular unleaded gasoline real price 4.2

3.7

3.2

2.7 2.58

Real gasoline price price Real gasoline 2.2 (U.S. dollars per gallon) per dollars (U.S. 1.7

1.2 1976 1980 1984 1988 1992 1996 2000 2004 2008 2012 2016 2020

Sources: Bloomberg, Energy Information Administration (EIA), Bureau of Labor Statistics, Wells Fargo Investment Institute. Top panel is quarterly data: March 31, 1976 - September 30, 2019. Bottom panel is weekly data: January 31, 1976 - January 6, 2020. Real gasoline price is adjusted for inflation by Consumer Price Index (CPI).

© 2020 Wells Fargo Investment Institute. All rights reserved. Page 7 of 10 Why did President Trump decline to escalate the Iran should work together to defeat ISIS (Islamic State Iran conflict? of Iraq and Syria, a militant terrorist group). By the time the speech was over, Brent oil had fallen to $65, At one point last week, after Iran launched missiles and gold to $1,560. into Iraqi military sites known to house Americans, it appeared that a full-blown war was imminent. Markets So, why did President Trump decline to escalate the even began to price war in. On the night of Tuesday, situation? We believe one possible answer is his re- January 7, futures for the Dow Jones Industrial election bid. Presidential approval ratings (Chart 7, red Average dropped by 400 points; Brent oil prices spiked dashed line) have been known to track the direction of to $70 per barrel; and gold rose to $1,610 per ounce. But gasoline prices (Chart 7, purple line [inverted]). In our the next morning, President Trump addressed the view, a protracted war with Iran in 2020 would likely nation, stating that he did not want to escalate the Iran not have helped President Trump’s re-election bid. conflict. At one point, he even hinted that the U.S. and

Chart 7. Gasoline prices versus presidential approval 1.25 95 Regular unleaded gasoline real price (inverted) Presidential approval rating 1.75 85

2.25 75

2.75 65

3.25 55 Presidential approval rating

Real gasoline price dollars (U.S. per gallon) 3.75 45

4.25 35

4.75 25 1977 1983 1989 1995 2001 2007 2013 2019

Sources: Bloomberg, Gallup, University of California, Santa Barbara, Energy Information Administration (EIA), Bureau of Labor Statistics, Wells Fargo Investment Institute. Monthly data: January 31, 1977 - December 31, 2019. Real gasoline price is adjusted for inflation by Consumer Price Index (CPI). Past performance is not a guarantee of future results.

© 2020 Wells Fargo Investment Institute. All rights reserved. Page 8 of 10 The “right” oil price in 2020 All in all, we believe that the 2020 oil prices that best Our 2020 year-end oil targets include a $10 geopolitical balance supply, demand, and geopolitical tensions are premium to compensate for heightened Middle East $60 per barrel for WTI crude oil, and $65 per barrel for tensions. Is this enough of a geopolitical premium? We Brent. believe so. The Iran drama likely will remain with us The bottom line through 2020, but both sides appear hesitant to The Middle East—and Iran specifically—still matters to increase hostilities, and escalation appears to be a low global oil prices. This was proven, once again, in 2019 probability. and 2020. With that being said, the impact of Middle With geopolitical tensions now deflating, oil’s East crises on oil prices typically has been short-lived, supply/demand fundamentals should increase their and this again appears to be the case. Historically influence over oil prices. Global oil demand remains speaking, Middle East turmoil does not typically relatively soft, and supplies are relatively healthy. influence stock markets, but spiking oil prices could Specifically on the supply side, the world’s largest sway the 2020 presidential election. For 2020, we petroleum producer, the U.S., continues to pump believe that $60 per barrel for WTI and $65 for Brent record amounts of oil. Additionally, there are plenty of are the prices that best balance supply, demand, and oil producers itching to produce more oil, such as geopolitical tensions.1 Russia and Saudi Arabia. Higher oil prices give them cover to do just that.

John LaForge John LaForge is part of the leadership team that develops recommendations and market commentary for real assets, which Head of Real Asset Strategy includes commodities, real estate investment trusts, and master limited Global Investment Strategy partnerships. In his role, he provides commentary and strategy across the Wells Fargo Investment Institute commodity spectrum, covering the most widely followed energy, metal, agricultural, and soft commodity groups. Mr. LaForge has focused primarily on asset management and investment research during his 23 years of investment experience. He is based in Sarasota, Florida.

Austin Pickle, CFA Austin Pickle is an investment strategy analyst for the global real assets strategy team headed by John Laforge. The team develops strategic and Investment Strategy Analyst tactical asset allocation recommendations and market commentary for Global Investment Strategy real assets, which includes real estate investment trusts, master limited Wells Fargo Investment Institute partnerships, and commodities. He is located in Sarasota, Florida.

1 Our year-end 2020 target range is $55-$65 for WTI and $60-$70 for Brent. © 2020 Wells Fargo Investment Institute. All rights reserved. Page 9 of 10

List of Middle East crisis events

8/2/1990 – Gulf War 7/11/2006 – India, Israel, and Lebanon Bombings 12/30/2013 – Anbar Clashes

3/1/1991 – Uprisings in Iraq 5/7/2008 – Lebanon Crisis 6/13/2014 – Iraq Civil War begins

12/16/1998 – Bombing of Iraq 12/27/2008 – Israel Invades Gaza 3/21/2015 – Yemeni Civil War (Operation Desert Fox) 10/12/2000 – U.S.S. Cole Bombing 4/27/2009 – Insurgency 7/15/2016 – Turkish Coup attempts

10/7/2001 – War In Afghanistan 12/18/2010 – Arab Spring Begins 6/19/2019 – Iran shoots down U.S. drone

3/20/2003 – Iraq War 10/20/2011 – Muammar Gaddafi Overthrown 9/14/2019 – Attacks on Saudi oil 1/26/2012 – Northern Mali conflict processing facilities 3/12/2004 – Al-Qamishli Riots 7/3/2013 – Islamic Unrest in Egypt

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