War, Oil and Uncertainty
Fighting in the land of oil, sometimes referred to as the Persian Gulf, has pushed the price of a barrel of crude over $100. The pressure threatens to get worse before it gets better. These extreme circumstances have elicited forecasts of raging inflation, an end to any hope for more affordable lifestyles, and recession. These are, of course, completely plausible prospects, but much else in the situation points to less dramatic and less frightening economic repercussions.
Relevant figures deserve a quick review. The fighting has closed the Strait of Hormuz, denying the world some 20% of its seaborn oil supplies. Every bit of Iran’s oil production must pass through the strait, just about all of it going to China. Most Saudi, Kuwaiti, Qatari, and United Arab Emirates (UAE) oil and gas must reach the world in the same way. Unsurprisingly, oil prices have soared. A barrel of West Texas Intermediate (WTI), the American benchmark, has seen its price rise from $62 in mid-February to just under $100 at the time of writing, an increase of about 60%. A barrel of Brent crude, the European index, has also risen about 60% over this time from $67 to $109.
How Much Could Oil Prices Rise Before Triggering a Recession?
Headlines, as always, have brought the public more than a touch of hysteria. Several have quoted a study that identified $138 a barrel as a crucial price that, if held that high for three months, would tip the economy into recession. Certainly another 40% rise in price would impose considerable economic pain and that pain, the longer it lasted, would have more pronounced economic effects. The possibility of recession would, accordingly, rise. But the $138 figure and the three-month duration offer a level of precision that invites skepticism among even the most earnest econometricians.
If this headline overstates what can be said about these matters, other popular commentary is simply wrong. More than one discussion concludes that the high cost of gasoline will cut into consumer spending. It might pay for such thinkers to keep in mind that the purchase of gasoline, even at a higher price, is a form of consumer spending. And to the extent that consumers save less in order to sustain their lifestyles while paying the extra for each gallon suggests that consumer spending might well rise as a consequence of higher fuel prices.
Why This Oil Crisis Is Different From the 1970s Energy Shock
There is also an understandable temptation to compare this immediate loss of oil supplies to the terrible economic harm done by the oil shortages of the 1970s, skyrocketing and stubborn inflation and a chronic tendency toward recession and stagnation. Tempting as such historical parallels are, the events of that troubled decade differ considerably from the situation today.
Then, the oil embargo imposed by the Organization of Petroleum Exporting Countries (OPEC) and the general shortages that followed created a widespread sense that fossil fuels would become increasingly scarce. Phrases like “peak oil” were popular. This sense of scarcity created an expectation that however high oil prices rose, they would only rise farther in the future and put that much more upward pressure on the overall rate of inflation and downward pressure on the economy. The ensuing momentum created by these expectations made it difficult, even when immediate pressures subsided, to secure inflation relief or reinvigorate the economy.
Little of this is the case today. Astounding efficiencies on fuel use, new drilling technologies, and the growing presence of alternatives have scotched all talk of “peak oil.” Indeed, for better or worse, the world today has the sense of oil and natural gas abundance. What is more, there is a growing sense that the North American supplies will quickly find ways onto world markets and that even if the Strait of Hormuz were closed permanently, oil producers on the Saudi Arabian Peninsula would construct pipelines and port facilities that could bypass the strait. Though it might take years for these fuel sources to become widely available, their very real prospect would remove the kind of permanent scarcity expectations that dominated the 1970s, created such an inflationary momentum at the time, and weighed so heavily on the economies of the world’s developed countries.
Can the Fed Avoid Repeating Its Inflationary Mistakes of the Past?
There is, at least potentially, another big difference from the 1970s. Back then, the Fed and other central banks tried to mitigate the real economic burdens of oil shortages by pursuing easy monetary policies. They poured money into their respective economies and so generalized and extended the inflationary effect of the rising oil and gas prices. Had the Fed and other central banks resisted this temptation, fuel prices would have risen and pushed up measured inflation rates, but the absence of monetary largess would have held back the prices of other products and mitigated the general inflationary impact of the oil price hikes. This time, the Fed and other central banks seem aware of past mistakes, as the recent decisions to hold interest rates steady seems to indicate. Should the Fed remain vigilant in this regard, the rise in oil prices would still add to inflation but not in the fundamental and persistent way seen in the 1970s.
Two Scenarios: Best Case and Worst Case for the Global Economy
Even with this as background, it would be a fool’s game to speculate on likelihoods against a backdrop of open warfare, especially in the Middle East. The best any honest analyst can offer are scenarios. This effort will consider two, a best-case outcome and a worst-case outcome, at least as far as economics is concerned. Reality will doubtless fall between them.
The happy possibility would include an early end to hostilities and a cooperative or at least less belligerent authority in Iran. That could result either from a successful public uprising or a chastened rump of the existing regime, as it seems is happening in Venezuela. Such prospects would involve a re-opening of the Strait of Hormuz to all shipping and invite strenuous efforts to repair the damage to oil and gas fields as well as shipping infrastructures across the region. These repairs would, of course, take time, but the oil would at least begin to flow, and the world would position itself for a greater future flow. Since such an outcome would remove the long-standing disruptive influence of the old Iranian regime, oil futures could eventually fall below pre-war levels. Wildcatters in West Texas and the oil majors would cry into their beer, but the rest of the economy would benefit. This happy view would also see the Fed avoiding the temptation to make the mistakes of the 1970s and so reduce any lingering inflationary momentum.
A worst-case alternative would involve extended fighting and a complete destruction of oil and gas fields in the region as well as shipping infrastructure. The world would lose the use of all the oil and gas that once passed through the Persian Gulf as well as Saudi and other facilities that had long-ago found their way to market via other means. Existing oil prices would continue to climb, and matters would leave all economies with little reason to look for price relief of additional supplies for the foreseeable future. North American supplies would in time flow more completely into world markets, but not likely in enough abundance to erase the Middle Eastern losses. To make matters worse, such a scenario would include a Fed that gives into the unfortunate temptations of the 1970s, generalizing and extending the immediate inflationary effects of rising oil prices. Such a world would repeat the painful pattern of recession and stagflation last experienced 50 years ago.
What the Odds Say and Why Uncertainty Remains
Betting markets as of this writing estimate a 53% chance that the fighting will cease by the end of April. If that works out, probabilities point in the direction of the happy scenario above, if not all its pleasant elements. But the people who do this betting are no more reliable than anyone else, and while the fighting continues, matters simply remain unpredictable, making it unwise to dismiss the above worst-case scenario or something like it.
