Money and Markets

In war, the most fatal mistake is to underestimate the enemy.

Likewise, in natural resource markets, the most costly blunder is to underestimate how far prices can go.

And today, the tendency to make both of these errors is more deeply ingrained in the behavior patterns of Washington and Wall Street than at any time since the Vietnam War.

Case in point: The tyranny of Iran and the irony of oil.

The Tyranny of Iran

Iran is the rogue terrorist state with chemical weapons and nuclear programs that Iraq turned out not to be.

Iran is the only country on the planet that is directly supporting international terrorism, officially vowing the destruction of another state, and openly defying the community of nations.

Iran is also the one country in the world today with both the ideology and the ability to take down the global economy.

And yet, while Tehran seems to have the chessboard of what-ifs and contingency plans mapped out, Washington is still playing checkers.

Here's how each and every move by the U.S. and its allies could be checkmated.

Move #1
Sanctions

On Friday, the UN's International Atomic Energy Agency (IAEA) slammed Iran for non-compliance with its ultimatum to cease its nuclear enrichment program. Now, to retain even a modicum of credibility, the UN's Security Council has no choice: It must respond with punitive action.

Almost immediately, the U.S. is going to move for a resolution under Chapter 7 of the UN charter, which includes the threat of military action.

To pass, the resolution requires a unanimous vote from all five permanent members - United States, Britain, France, China and Russia. But if China or Russia threaten to veto the resolution, the U.S. will offer them some concessions to win them over.

And even if the Security Council is still stalemated, the U.S. has vowed to bypass the United Nations, team up with as many other countries as are willing, and slap Iran with its own sanctions - freezing Iranian assets, blocking travel by Iranian diplomats, and more.

Checkmate: The oil weapon! In an interview with the Wall Street Journal last week, Iran's Oil Minister Kazem Vaziri Hamaneh flatly told the world precisely what the world should already know - that Iran has the capacity and the willingness to disrupt world oil markets. His exact words:

"The need of the world for energy is soaring, and if Iran is taken out of the equation, prices will shoot up and there will be big difficulties in the energy markets."

Indeed, just the threat of a temporary slowdown in Iranian crude oil exports has already helped drive prices to their highest level in history. So imagine what the impact will be if Iran actually removes some portion of its oil from the market!

Iran currently exports 2.5 million barrels of oil per day. But the margin of excess supply available in the world today is, at best, ranging from 0.5 to 1 million barrels per day. So to wipe out most or all of the excess, all Iran would have to do is cut off about one-quarter of its exports.

Yesterday's Contra Costa Times puts it this way:

"Iran's key ally in the current nuclear crisis is not Russia or China. It's oil. Tehran can easily drive up prices and is already beginning to do so to rattle the West. In the end, Iran's petro power will probably trump Western diplomacy.

"Just look at what's happening: Tehran's bravado announcement April 11 that it had mastered key nuclear technology ... drove oil prices to more than $70. Prices have risen more than $8 a barrel in less than three weeks, primarily because of Iran."

In short, Iran has the most powerful economic leverage of any rogue country in modern history.

Move #2
The Threat of Military Action

If the U.S. gets its way in the Security Council, it will be the United Nations that threatens military action against Iran.

If the U.S. doesn't get its way, and the final Security Council resolution is watered down, it will threaten military action independently or with leading European nations.

And even in the unlikely event that the U.S. backs off, Israel will not. As I told you in last Monday's Money and Markets ...

"Israeli Intelligence chief Dagan has declared that a nuclear Iran is 'the worst-ever threat' to the country's existence. Israel's Defense Minister Shaul Mofaz has stated that 'under no circumstances would Israel be able to tolerate nuclear weapons in Iranian possession.' Israeli Intelligence has even revealed plans for attacks by F-16 bombers."

And just last week, Israel's interim prime minister, Ehud Olmert, made a statement which can only be interpreted as the prelude to a declaration of war:

"[Iran's president] Ahmadinejad speaks today like Hitler before taking power. He speaks of the complete destruction and annihilation of the Jewish people. ... We are dealing with a psychopath of the worst kind ..."

Checkmate: The Strait of Hormuz! This is the narrow, four-mile corridor between Iran and Oman through which every single tanker leaving the Persian Gulf must pass ... the single most vital "choke point" on the planet ... the one strategic location that, if disrupted, could sink the global economy.

And yet, it sits right in the bowels of Iran.

This is not something Iran is ignoring. Indeed, less than one month ago, the Supreme Commander of Iran's Islamic Revolutionary Guard, Major General Yahya Rahim Safavi, called the Strait of Hormuz the "economic lifeline" of the West and said Iran could use it as a vehicle for wreaking economic havoc.

Nor is this a novel idea. During the Iran-Iraq war, Iran's President Ali Rafsanjani said: "We would close the Strait of Hormuz if the Gulf became unusable for us. And if the Gulf becomes unusable for us, we will make the Gulf unusable for others."

How would Iran block the Strait of Hormuz? John Burke, an ex-Marine intelligence specialist and a member of our Money and Markets team, explains it this way:

"Iran can deploy helicopters, dedicated mine layers and Russian-built Kilo-class submarines.

"Iran can launch its large fleet of fast-attack 'swarm boats.'

"It can also deploy its vast array of sea, air and land-launched missiles targeting commercial and military ships that must pass through the Strait.

"Although the West might prevail and secure the Strait, the cost of that victory could ultimately amount to nearly doubling the world's oil bill and more than doubling your gas bills."

Is John overstating the case for exploding oil prices? I think not. The Persian Gulf is responsible for

• 32% of the world's oil production capacity ...

• 45% of the world's natural gas ...

• 57% of the world's oil reserves, and ...

• 100% (and more!) of the world's excess capacity.

Problem: About 90% of this oil and gas passes through the Strait of Hormuz. Only about 10% leaves the region through alternate routes, such as East-West oil pipeline across Saudi Arabia to the port of Yanbu or the Abqaiq-Yanbu natural gas line across Saudi Arabia to the Red Sea. And even those alternate routes are vulnerable to attack by Iran or by terrorists.

Bottom line: Just as soon as - or even before - the West threatens Iran with military action, Iran can threaten the Strait of Hormuz, cut off up to one-third of the world's energy supply, and drive prices into the stratosphere.

Move #3
Pre-Emptive Attack

Remember: U.S. officials may be talking diplomacy. But they're thinking military action.

The only major question remaining: who would launch the first pre-emptive strikes against Iran? The United States or Israel?

It would certainly not be a novel event for either country.

Under similar, but less threatening, circumstances, the U.S. has launched pre-emptive air attacks on Libya, Sudan and Iraq. And back in 1981, when it was feared Saddam Hussein was developing the capability to build a nuclear weapon, Israel launched a preemptive attack to destroy Iraq's nuclear reactor in Osirak.

So no one in their right mind should scoff at the notion of the U.S. or Israel striking key strategic targets on Iranian soil.

Checkmate: The threat of international terrorism that would make al Qaeda seem tame by comparison.

I warned you about this on March 13 (see Stealth War) when no one wanted to talk about it. Now, it's all over the press.

At that time, I wrote:

"Washington still thinks al Qaeda is the biggest threat to America's interests. But in the days ahead, you're going to hear more about an organization that most Americans never knew existed: al Quds.

"Unlike al Qaeda, al Quds is not a nationless, renegade band. It's a highly organized strike force now operating in Iraq under the control of Iran's elite Revolutionary Guard.

"And unlike al Qaeda, al Quds doesn't have to beg for refuge or financing. It gets all the protection it needs on Iranian soil ... and all its funding from the Iranian treasury, which, in turn, is liberally lubricated with oil money.

"Moreover, al Quds (meaning "Jerusalem") is not an upstart band.
For about two decades, al Quds has been operating in Lebanon, providing military guidance and support for terrorist attacks against Israel, especially those carried out by Hezbollah and other Islamic terrorist organizations.

"For many years, al Quds has also been operating as an elite international hit squad, responsible for political assassination in Europe and the Middle East.

"Most disturbing of all, al Quds is joined at the hip with the most powerful militia currently operating in Iraq - the Badr Brigade ...

"Moreover, a person who has played a prominent leadership role in the founding and training of both al Quds and the Badr Brigade is none other than Mahmoud Ahmadinejad, now the president of Iran."

In sum, even without deploying its chemical weapons and even without playing the nuclear card, Iran has three ways it can checkmate the West. Iran can:

• Choke off all or most of the world's excess oil supplies simply by slowing down its own oil exports.

• Cut off as much as one-third of the world's energy supplies!

• Terrorize the globe in a way that would make al Qaeda look like an impotent eunuch.

The Irony of Oil

Despite all these threats, most people regard oil as "already high" and therefore "unlikely to go that much higher."

It's the classic mistake made by amateurs and professionals alike.

Their error: They greatly underestimate the potential surge in the price of natural resources that are both critical and scarce.

The key to remember:

Even without a crisis in the Middle East or a blow-up in the Persian Gulf, oil prices have been moving inexorably higher for four years. Even absent the three ways Iran can checkmate the West, the surging worldwide demand for oil is unwavering.

That's what's responsible for the long-term uptrend in oil prices that you can see in this chart. And that's what is now driving oil prices to $80, $90, or even $100 per barrel.

So with any retaliation by Iran against UN or U.S. sanctions, you can expect oil prices to rise at an even faster clip, accelerating above and beyond its current pathway.

Does this kind of acceleration actually occur with some degree of frequency in natural resource markets? Absolutely. In fact, it's just happened in a market that often foreshadows the moves in oil and other natural resources - gold.

Like the crude oil market right now, last year's gold market was also moving upward in a steady channel. And like the crude oil market, gold is driven higher both by cyclical economic forces and geopolitical threats.

The difference: Gold is a smaller market and more sensitive to these threats. Oil markets are broader and take a bit longer to react.

That's why gold's rise has accelerated this year, while oil's price rise has still been contained to a steady upward pace. That's why gold went through the roof on Friday, but oil was a bit slower to move.

But what you see today in gold is a sneak preview of what you may soon see in oil, especially now that the Iran crisis is on the verge of blowing up.

What to Do

You don't have to assume a crisis to invest in this situation. Even if Iran and the West kiss and make up, oil is being driven higher by surging demand:

American drivers are complaining loudly about pain at the pump, but they're doing next to nothing to cut back on their gas-guzzling driving.

China and India are choking on the smog, but they're not lifting a finger to hold back their industrial juggernauts.

So the only way oil prices are going to come down is if they go up sharply first. Dramatically higher oil is the only force capable of curtailing demand. And therein lies the irony of oil.

That irony, however, is your profit opportunity. It gives you the relative certainty you need to help reduce downside risk ... plus the relatively good probability of blowout success.

No one can predict the future with precision, and risk of loss is forever present. But it's this kind of heads-you-win-tails-they-lose situation that's the holy grail of investing.

And for funds you can afford to invest more aggressively, go for the greatest leverage of all, with a nice comfortable time horizon, and with a risk that can never exceed your investment.

One last word: No matter how strongly you may feel about this opportunity - or any other for that matter - always be sure to invest most of your money conservatively, with a big allocation to short-term Treasury securities or equivalent, as far as possible from harm's way.

Good luck and God bless!