Quick Bites | Will Oil Spike the Global Economy?

The US-Israel campaign against Iran has revived geopolitical risk, with the key market implication hinging on the oil price and the duration of disruption in the Strait of Hormuz. The operation to date has been regime-damaging but not regime-changing. The situation remains fluid amid the fog of war, but altered transit through the Strait of Hormuz is likely to persist in the near term.

Source: Financial Times

How serious is this shock? 

Oil prices have reacted far more sharply than they did to last year’s 12-day war between Israel and Iran, which saw no halt to energy flows from the Gulf and limited attacks on energy infrastructure. This time it’s different, with Iran seemingly determined to attack its Gulf neighbours and increase the cost to the US and its European allies.

Source: Uncharted Territories, Tomas Pueyo

Recent moves in the oil price are hardly severe compared to past conflicts. The 1973-74 Arab oil embargo saw prices surge by 260%; the upheaval following Iran’s 1979 revolution drove a jump of 160%; and Iraq’s invasion of Kuwait in 1990 triggered an increase of 180%. Each of these episodes had an impact on the global economy far beyond the energy sector. 

Why have prices not surged further?

The world has changed. Developed economies are far less oil intensive than they were in the 1970s, and much less dependent on oil from the Middle East. The US is now the world’s largest oil producer, and new oil is coming on to the market from Guyana, Brazil and Canada. 

The market may also be second-guessing the Trump administration. Ahead of midterm elections in November, the White House has a strong incentive to keep a lid on inflation. Any sustained price rise could be tempered by releases from the US Strategic Petroleum Reserve. 

The oil industry has become an expert at handling a crisis. After managing the Covid-19 pandemic and Russia’s 2022 invasion of Ukraine, during which global energy flows were rewired, traders have become skilled at rapidly rerouting tankers to maximise profit and minimise disruption. The experience has made the market more relaxed, and perhaps complacent, about short-term supply shocks. 

Source: BCA Research

The oil market had been well supplied in the months before the conflict, allowing countries that feared problems in the Middle East to build up their stockpiles of crude. China, for example, has enough oil stored to cover 124 days without new deliveries, while Australia’s stockpiles are relatively meagre, estimated as follows: Petrol: ~39 days of average consumption; Jet fuel (kerosene): ~31 days; Diesel: ~33 days.

Global stockpiles are low by historical standards but still amount to roughly 2bn barrels. Additional buffers include the oil already at sea outside the Gulf and another 120mn to 150mn barrels on tankers linked to sanctions-evading trade involving Russia or Iran. In an extreme scenario Russian barrels could return to the market.

Of course, the longer and higher the oil price goes, the further it will impact inflation and the outlook for interest rates.

Central Banks will be watching

Source: BCA

Some countries will handle the crisis better than others

A sustained energy shock would have divergent implications for developed market central banks. At around $78/bbl, oil is not especially concerning for Fed policy, but a prolonged shock would warrant closer inspection.

In the US, higher oil prices will eventually translate into higher production, yet the key variable for the Fed would be inflation expectations. While theory suggests central banks should look through a supply-side inflation shock, the bar for rate cuts in the US is higher given inflation is still above target and leading indicators have shown signs of reheating.

Europe is far more vulnerable to rising energy prices, with inflation near or slightly below target. The European economy has natural gas as a key input. LNG prices rose more than 30% on Monday. Qatar’s decision to halt LNG production is a key development that, if sustained, would have profound implications for European price stability.

A prolonged energy shock (not our base case at this time) would weigh on energy importers and pressure the EUR, JPY, and CNY. On the other hand, the USD and commodity exporter currencies such as the CAD and AUD could even benefit.