The Middle East is on fire again. Hezbollah, the Shia militant party that controls southern Lebanon, killed eight and kidnapped two soldiers in a raid on Israel last week. The offensive prompted a retaliatory bombing campaign to subdue Hezbollah that has left more than 200 civilians dead; Hezbollah has fired rockets on northern Israeli towns. For the past month, Israel has been shelling the Gaza strip to stamp out the firing of rockets by Palestinian militant group Hamas. Israel is confronted with “a war on two fronts with proxy terrorists” armed by Iran – who support Hezbollah – and Syria (which shelters Hamas), says The Wall Street Journal.
Another oil shock? Violence in the Middle East
But its tactics are questionable, according to The New York Times. It should be attempting to weaken and isolate Hamas and Hezbollah by targeting its leaders and fighters more directly and minimising civilian casualties; at present, it risks giving them an opportunity to radicalise Arab politics through a heavy-handed military response. So what next? Israel is against UN involvement and seems determined to crush Hezbollah – even though, as the FT points out, the organisation didn’t exist until Israel mounted a full invasion of Lebanon in 1982 in a futile attempt to wipe out the PLO. Throw in concern that Israeli prime minister Ehud Olmert is an inexperienced military strategist, and it’s no wonder there are fears of a regional war that could draw in Syria and Iran.
This explains the jitters in the oil market that has propelled black gold to a record $78 a barrel during the past few days, sending major equity markets into a tailspin. The Middle East accounts for almost a third of the world’s oil output and two thirds of its untapped reserves; Iran alone holds 12% of global oil. With virtually no spare global production capacity and the hurricane season approaching (see James Ferguson on the real reason for the oil price rise) the prospect of a supply shock from the Middle East has made oil boil over. Eighty dollars a barrel is now a realistic short-term target.
According to Peter Beutel of energy consultancy Cameron Hanover, if the situation deteriorates to the extent that Iran decides to block the Strait of Hormuz, through which 25% of the world’s oil is shipped, oil prices would go far higher; throw in a hurricane and “we will see $100”, he says. Longer-term, it’s no good counting on a significant slide in oil prices if geopolitical worries abate; as MoneyWeek noted recently, demand is already close to exceeding supply and is set to jump by 48% by 2030 as Asia industrialises and America’s appetite rises; new supplies, however, look unlikely to catch up, given the lack of large-scale discoveries in recent years.
Another oil shock? Worries over global slowdown
Violence in the Middle East and high oil – this looks like a classic recipe for a global economic downturn. As Larry Elliot points out in The Guardian, the last three serious worldwide slowdowns were each preceded by a spike in oil prices and linked to a crisis in The Middle East: the Yom Kippur war of the early 1970s, the Iran/Iraq war in 1980 and Saddam Hussein’s invasion of the Gulf in 1990. So what will happen this time?
So far, an oil spike has failed to dampen a growing world economy blessed with moderate inflation. A report from the OECD and IMF two years ago calculated that each $10 per barrel increase in the oil price would shave an annual 0.5 percentage points off growth for two years, says Edward Hadas on Breakingviews.com. So the fourfold increase from $20 over the past five years should have shaved 6 percentage points off growth. But the world economy proved resilient because easy money offset the oil price rise; consumers racked up debt instead of reining in spending. But now, oil and interest rates are climbing, which, even if the Middle Eastern conflict remains contained, could “prove much trickier to manage”.
That’s putting it kindly, given the legitimate worries over a global slowdown before the latest Middle Eastern imbroglio hit the headlines. Leading indicators of the global economy point suggest a US-led slowdown is already under way, with the OECD’s leading indicator revealing slower growth for the second successive month and the US sub-index especially weak. Dresdner Kleinwort Wasserstein expects the US GDP growth to slow to 2.5% (down from over 5% in the first quarter) and adds that “higher oil prices can only intensify the pressure”.
Last week brought news of unexpectedly weak retail sales and consumer confidence. This highlights the fact that the US consumer, long the key engine of global demand, is becoming “increasingly worrisome”, as Stephen Roach of Morgan Stanley puts it. Income growth has been weak, with weekly wages adjusted for inflation down 0.2% over the past year, while the slowing housing market and higher mortgage rates are preventing consumers refinancing their mortgages and thus freeing up money to spend – a process that has underpinned growth for the past few years. Sky-high debts and recent rises in energy prices are putting further pressure on consumption.
Another oil shock? World economy already vulnerable
Note that the last two oil shocks kicked in when the world economy was already softened up by other factors, says Roach. In 1979, global growth had slowed to 3.8%, down from a 4.7% annual clip in the three previous years; in 1990, expansion had slowed to 2.9%, down from 4.2% in the previous three years. So while the world may now appear to be in better shape with a fourth successive year of growth in excess of 4% on the cards, it’s worrying that the key driver of global demand looks so vulnerable to a shock. For the rest of “what is still a largely externally dependent global economy, a consolidation of the American consumer can hardly be taken lightly”.
Take Asia. Morgan Stanley’s Andy Xie, noting that the US is the biggest market for Asia and that oil is crucial to the manufacturing-intensive region, calculates that rising oil prices and slowing US demand could cut Asian growth by more than 2% in the second half of this year – “the biggest shock to the region since 1998”. And another six months of the twin trends could push several of the economies in the region into recession. With Germany’s recovery still largely driven by exports and
debt-addled consumers in Britain hardly in a position to boost spending and the economy, the global outlook is hardly encouraging. If oil hits $100,
look out below.