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The Daily Reckoning PRESENTS: Of all the geopolitical events looming on the horizon for America, the largest one is the potential for conflict with Iran - which would certainly cause a major change in the world economy. Dan Denning offers his advice for investors who are willing to prepare for the unexpected...

FINANCIAL TERRORISM

by Dan Denning

Contrary to what you see in the press, though, the average Frenchman or woman is not that different from you, except, perhaps, at the dinner table. The French take their food seriously. A cup of coffee or a three hour dinner is not just about the quality of the food or the wine. Eating is a social experience in France. What's more, serving food is a serious profession for which men and women go to school in France.

That may seem silly to Americans. But you can see why a Frenchman who deals with food professionally chafes at being bossed around by Americans who deal with food recreationally. For the French, food is serious pleasure, to be relished and treated with respect. For Americans, food is serious business, to be consumed and treated with salt.

Americans want prompt service, healthy portions, and plenty of attention for an extra fork, some more napkins, or another Coke. The French want to be left alone to eat, talk, and digest. I am convinced that much of the animosity between America and France stems from the difference in the way we treat food. A lot would be resolved if both nations treated food the way the English do, namely as something to be deep-fried, eaten, and tolerated between cups of coffee or pints of lager.

This culinary side trip has served a purpose, I hope. When you visit foreign countries, it takes you out of your comfort zone. Other people have different customs. The food is different. Often the language is different. Making yourself uncomfortable causes you to see things you wouldn't otherwise see. It changes your perspective. It's also a way of showing yourself that what once seemed too challenging to attempt is actually not as hard as it looks. But what does it mean to make yourself uncomfortable as investors? There are three answers to this question.

First, it means being bold enough to think unconventionally. This, of course, is the whole bull hunter philosophy. You recognize that the world is always changing and that what worked yesterday may not work tomorrow. You are willing to try new approaches to achieve your investment goals.

Second, it means using all the tools at your disposal. This can sometimes be even more difficult than allowing yourself to think differently. Most of us are lazy. We'd do as little as possible to achieve our investment goals, if we could get away with it. But these days, doing as little as possible is the same thing as doing nothing at all.

Finally, you have to be willing to ask the questions no one else wants to ask. In the investment world, thinking about the future can be a dangerous game. You can't predict the future. If you invest your money based on faulty predictions, you could easily lose it. Yet the investor's greatest challenge is to figure out what price to pay today for future earnings that are unpredictable. The further you go into the future, the harder it is to tell what tomorrow will bring and what you should be willing to pay for it today.

But the stock market looks ahead, not behind. And so we have to look ahead, too, to try to see what's coming, if not in the earnings picture, then at least in the bigger picture. You're going to be investing in a stock market driven by geopolitical events as much as earnings, probably for the rest of your investment life. That means trying to decipher what events like war in the Middle East or high personal debt levels in America might mean for the stock market.

It's also possible to look into the future and make some intelligent speculations on what might happen. Using options on index funds and exchange-traded funds is one way that modern investors can insure themselves against large, macroeconomic risks. It is not foolproof insurance. And it is not without risk. But in a dangerous and uncomfortable world, it is one practical way to begin putting the tools at your disposal to work.

In a speech I gave in Chicago in 2004, I made the case for $100-a barrel oil to 150 options investors. They were shocked, skeptical, and intrigued, by turns. I told them that event-driven investment moves - the kind where an external event shocks markets and causes a big move up or down in a sector or the whole market - are nearly impossible to predict. But strategic foresight can help you prepare for some of them.

One of the largest geopolitical events looming on the horizon today is a potential conflict with Iran. Iran is a charter member of President George W. Bush's Axis of Evil. Iran is near the top of the president's foreign policy agenda for his second term. At stake is whether Iran will become a nuclear power. It's not clear how this would change the world. What is clear is that the mullahs who run Iran have a strategic vision of their own. To investors, what ought to be even clearer is what the consequences of a war with Iran would mean: $100 oil.

Any economist worth his or her pocket protector will tell you that $100 oil is not economically sustainable. The world simply could not afford to pay $100 for a barrel of oil - for a sustained period of time. It would create a world of oil haves and have-nots, and might even precipitate oil wars between nations desperately competing over a scarce and expensive natural resource. Not only would it drive U.S. gasoline prices to unimaginable heights, the shock of such a dramatic rise in energy costs would throw the world's economy into a deep and painful recession, if not a depression. But that doesn't mean it couldn't happen anyway - at least for a few days or weeks.

You don't have to be Dr. Strangelove to envision what the Iranian strategy might be against the U.S. economy. I say economy and not military. The nature of an Iranian counterattack would mostly likely be to strike against U.S. economic interests. And what greater interest than oil? After all, it's much easier to drive the price of oil to $100 a barrel and instigate a political firestorm in Washington, D.C., than it is to defend against American strategic bombers and precision-guided munitions. Iran knows that America and all of Europe and Japan are addicted to oil.

Much of that oil comes from the Persian Gulf and must physically pass through the Strait of Hormuz to get to its final destinations. By choking off the supply of oil at this strategic point, Iran could exert enormous pressure on the United States, which would itself be pressured by those who desperately count on Middle East oil and want no part of America's quarrel with Iran.

With such a potentially high economic price to pay for a war with Iran, I've been told by some strategic investors that the United States would never risk it. But here is a question to make you uncomfortable: If it is plain for all to see that the way to America's weakness is through interrupting the flow of oil from the Persian Gulf, isn't it just a matter of time until someone tries it? Instead of fighting a war conventionally, why not try economic warfare, attacking what makes a country strong to begin with - its economy?

In total economic warfare, you attack a country's access to natural resources or its currency. By attacking its economy, you indirectly weaken its ability to attack you militarily.

If not Iran, then perhaps al Qaeda? And if not at the Strait of Hormuz, then perhaps at the Saudi oil refinery of Ras Tanura, one of the world's biggest and most productive? Even the British Broadcasting Corporation (BBC) sees what could happen. In 2004, the BBC aired a docudrama about what's been called an "energy Pearl Harbor."

Here's how it works (in the mind of the BBC). A rogue Middle Eastern oil trader works for a major money-center bank. Working in concert with his terrorist conspirators in Saudi Arabia, the trader takes an enormous leveraged position short crude oil, much as a hedge fund or institution might. At the same time, al Qaeda terrorists target the Saudi oil facility of Ras Tanura, the largest oil complex in the world. Ras Tanura cranks out almost 4.5 million barrels per day. Former CIA agent Robert Baer wrote in his book Sleeping With the Devil (Crown, 2003) that an attack like the one on the U.S.S. Cole in 2000 could knock out Ras Tanura for weeks. Baer also speculates that if the oil processing facility of Abqaiq were attacked via a hijacked jetliner, it would reduce Saudi production by as much as 4 million barrels per day for up to seven months.

You get the picture. The trader takes a huge position short. The oil price spikes on the terror attack. The leveraged short position becomes a form of financial terrorism. The banks' losses mount to the stratosphere. They hit their capital reserve requirements. They must liquidate others' assets. They are forced to sell, causing a wave of selling by other financial institutions.

The BBC presentation of the story morphed into the trader's "real" motives. He was upset with his bosses' focus on profits and turned out not to be in collaboration with al Qaeda. It's all fiction anyway. But if you were looking for a way to put Western economies in checkmate, sending the oil price sky-high and precipitating a financial crisis at the same time, it's hard to think of a better way - if you practiced total economic warfare, that is.

Regards,

Dan Denning

for The Daily Reckoning

Editor's Note: Dan Denning, editor of Strategic Investments, is one of America's most respected "big picture" analysts working today. The above essay was adapted from his new book, The Bull Hunter.

In The Bull Hunter, Dan lays out all the details of how to profit in ways most investors never imagined just five years ago. What's more, he'll show you why it's never been more dangerous to put all your investment eggs in the basket of the U.S. economy. It's a timely warning, along with an exceptional opportunity.

Daily Reckoning readers can purchase their copy at a 34% discount - just click here:

The Bull Hunter http://www1.youreletters.com/t/157475/4459110/776769/0/

-- Posted Wednesday, 29 June 2005 | Digg This Article