As the situation in the Red Sea escalated, I decided to write an emergency update about it.
I expect this to be highly relevant to most portfolios, so it should not be ignored.
As a shameless plug for my recently opened YouTube channel, I will first reference to my video that looks at the 3 trading chokepoints of the Middle East.
Context
More precisely, what is happening is that Yemen rebels (which are in practice a stronger force than the “official” government) are firing at ships passing nearby, both civilian and military.
This is made very easy by how narrow the Bad-al Mandeb strait is:
The place is also known as the Gate of Grief or the Gate of Tears, due to how narrow and difficult to navigate it is.
And that without anyone firing missiles at ships.
The broader context is a little complex, but can be summarized roughly as such:
Yemen was in a civil war that lasted a decade and was mostly a proxy war between Saudi Arabia / UAE and Iran. Terrible death toll on civilians as a result.
The Yemeni rebels, the Houthis, essentially emerge victorious by surviving a brutal bombing campaign and inflicting serious loss on advanced equipment from their enemies.
The military failure was partly behind the Saudi decision to bury the hatchet with Iran, and stop proxy wars in Yemen and Syria, under the diplomatic tutelage of China.
Iran, Saudi Arabia, UAE, and Egypt are all joining the BRICS. So is Ethiopia, on the other side of the Bad-Al Mandeb strait.
This had the effect of freeing the hands of Iran to support Hamas, Hezbollah, and the Houthis to fight Israel instead of the Saudis.
The Houthis are VERY well equipped with a massive stockpile of missiles and drones, most of them domestically manufactured by Iran (which retro-engineered Western, Chinese, and Russian designs).
The West has a few military bases directly in the region in Djibouti, especially the US and France.
Recent Events
Many ships, at first Israeli and now Western in general, have been targeted successfully by the Houthis. No military target got damaged yet, but many had to activate their anti-missile systems to survive the attacks.
Overall, the existing defense presence seems to have been inadequate to protect the sea lanes, a central tenet of the Pax Americana and American international position:
Most notably, at least one of the hits was done on a moving target with a ballistic missile, making it a world first as far as I understand it.
I emphasize this fact to give you the right mindset about the Houthis. Think less of them as rebels in sandals and Kalashnikovs, and more very sophisticated and well-supplied Vietkong-type of opponents.
In response, virtually all large shipping companies are now avoiding the area and will need to go around Africa instead.
If all the Suez Canal traffic did that, it would boost global oil consumption by 500,000 barrels per day and increase shipping costs strongly (remember the “crisis” of the Evergreen ship blocking the Suez Canal?)
In response, the US is essentially going to war with the Houthis, in a new operation dubbed “Operation Prosperity Guardian“.
The coalition carrying it is rather revealing.
It is basically any country in Western Europe with a half-decent Navy (aka forget Germany) + Bahrain and the Seychelles that got dragged into it for some pretense of international support.
This means only ONE Middle Eastern country, and a very small and irrelevant one at that, Bahrain. And no Red Sea nation at all.
For that matter, no Asian country at all, even US allies like Japan or the Philippines using extensively the Red Sea trade lanes either did not get invited or refused to not risk getting involved in a Middle East war.
A Historical Moment?
On paper, Yemen is no match for the mighty US Navy.
In practice, it can get a little more complicated.
The original post on X detailing this topic is more detailed, but here is the rough math:
Anti-missile and drone defense is handled by support vessels attached to a carrier group, mostly cruisers and destroyers.
With 8 of them attached to the Ford and Eisenhower carrier strike groups, that makes for 800 missiles. European allies will bring extra support, but not that much either.
From the Ukraine war, we can learn that a successful interception usually consumes 2-3x more defense than the incoming projectile.
Each of these ships cannot reload ammunition at sea but needs to go back to a safe harbor to do so.
Point defenses are more flexible, but less reliable against missiles (design or shells and drones) and really a last resort as a result.
So there are 3 distinct risks for the US Navy here:
Saturation attack, risking overwhelming the defense briefly, letting some missiles fly through and hit a high-value target. If very unlucky, a $500,000 missile can severely damage a $10B+ aircraft carrier.
Attrition tactics, where continuous attacks deplete the air defense until it runs out of ammo.
Economic attrition: roughly what the Houthis have been doing to the Saudis in 10 years of conflict. Take bombing and human losses, but keep fighting with a very tight budget while inflicting expensive losses on the enemy.
Here the risk is a durable blockade of the Red Sea, costing the European (and Asian) economies tens of billions in extra shipping costs and slower supply chains for a few tens of millions in missiles.
Each of the risks is to be handled differently.
Saturation
The saturation attack is a possibility but would be a big gamble by the Houthis. Because if it fails, they will be durably weakened, might expose their stockpile to retaliatory strikes, and might even endanger their political position domestically.
But if it works, it would be an absolutely devastating blow to the US image to lose a ship to a poor country like Yemen.
Attrition
The attrition tactics are more likely. The idea is to stretch even thinner the already depleting US/NATO supply chain. This also plays in favor of Russia & China, so it is likely that they will push Iran/Houthis in that direction if they can.
Economic Damages
Economic attrition is VERY likely. This is because removing 100% of the threat of attacks will be very difficult. It might require a land invasion. And we know from Iraq and Afghanistan how costly and difficult these could be.
With the US already under regular mortar and missile attacks in Syria and Iraq, this could force the US to essentially abandon the Pacific theater. Which might be a given anyway if Israel goes to war in Lebanon.
And of course, the West’s strategy in Ukraine and now with Yemen is to shoot down a target worth $25,000 with missiles costing $2,000,000 to protect a $100,000,000 ship…
Investing Takeaways
Regional Danger
The first investing takeaway is to be VERY careful with any company doing significant business in the Middle East. This includes jack-up drillers.
The area is heating up and might get a lot worse.
The absence of the Saudis or the UAE from a coalition defending navigation in the Red Sea is also a dramatic shift.
They will be ready to let America be on its own rather than risk missiles at their tankers. Any investment thesis assuming that Riyadh, Doha, or Dubai is “safe for investing” should be reconsidered.
Egypt Collapse?
30% of Egypt’s budget is derived from the Suez Canal fees. No exiting the Red Sea, no Suez Canal fees.
The country has been tethering on the brink of economic disaster for a while now. Corruption, low productivity of its workforce, and massive explosion in population beyond the land carry capacity, all contribute to a ticking time bomb.
Add the war in Gaza and the prospect of 1-2 million Palestinian refugees, and Egypt might become a new failed state right next to Post-Gaddafi Lybia and its slave market.
Besides the recent conflicts in the area, Egypt is also a prime candidate for an Emerging Market debt crisis due to rising interest rates, together with Tunisia, Bolivia, Argentina, Ethiopia, etc...
I am not sure there are easy ways to short Egypt, but this is a promising trade if you can find how to execute it.
The VanEck Egypt Index ETF EGPT might be a good target for this, even if I worry a little about liquidity.
Take note I have no idea whatsoever why this ETF has been rallying in the last 6 months, so be careful with a naked short. Out-of-the-money options might be less profitable but with fewer risks of open-ended losses.
The Trade Of The Year?
The shipping industry has been a disaster for investors in 2023.
The poster child of this is ZIM Integrated Shipping Services Ltd. (ZIM), with a 90% loss from the top in 2022 to the bottom hit a month ago. It has since rebounded from $6.59/share to $9.77/share.
A key effect of avoiding the Red Sea is extending sea travel time by 9 days and 7,000 km.
If considering the same supply of cargo ships, this is the equivalent of taking out a significant percentage of the shipping world’s capacity. It could boost the shipping dayrate dramatically.
I am not sure what the price for the global economy will be. But considering the Suez Canal fees the industry was happily paying was almost $10B last year, this means that the extra fuel and time cost will be higher than that.
Some out-of-the-money options on major shippers like Maersk or ZIM might be a way to play this with serious leverage while committing little capital to the idea.
Air Defense Manufacturers
Raytheon (RTX Corporation - RTX) is the provider of the SM-2 and SM-6 missiles for US Navy air defense.
It currently produces only 50x/year SM-2 and 150-200x /year SM-6. Plans to double that production by 2028 are ongoing, and might or might not happen.
Still, even if horribly inefficient in the long run, every SM-6 fired is an extra $5M in Raytheon’s pocket. Fire a few hundred of them and we are soon talking real money. And the Navy will not change its defense systems overnight.
A cheaper option and one likely to be used a lot these next months is the Phalanx produced by General Dynamics (GD) (the land version of the Phalanx, the C-RAM, is also very useful in Syria and Iraq).
The Leonardo Group (LDO.MI / FINMY) is a provider of electronic warfare and short-range point defense that could help as well.
And then, the more aerial threats against the US Navy grow, the more upgrades and extra need for the Aegis System by Lockheed Martin Corporation (LMT).
My best pick would go to General Dynamics, for a variety of reasons:
A new land war in Yemen would be a bounty for its armored vehicles business.
The damaged ships will need to be repaired in GD shipyards.
The Phalanx is becoming increasingly THE relevant and available technology against abundant and cheap threats like the Iranian Shahed drones, but also easily hidden “dumb” rockets and mortar that cannot be countered by Electronic warfare.
For the reasons outlined in the corresponding reports below, Leonardo is second best, but more relevant to the overall threat of drones than the Yemen escalation specifically, where General Dynamics is more relevant.
Electronic Warfare Made In EU (part 1)
Electronic Warfare Made In EU (part 2)
Congratulations on the launch of your new YouTube channel! Should be fun.