Global economic Impact

Global Economic Impact

What will be the nature of the regimes that come to power in countries affected by this turmoil?

What new economic systems will take hold? How severely will oil production and oil prices be affected by the spreading turmoil and subsequent realignment of political power? 

We cannot honestly know whether the political contagion will affect other countries in the region as it has Tunisia, Egypt and now Libya. But it would be foolish not to consider that in many countries, including Algeria, Bahrain, Jordan, Yemen and Iran, the likelihood of regime change has risen significantly. In the medium term, even apparently secure regimes in Saudi Arabia, Syria, Morocco and some other Gulf states may be under threat.

The implications for global energy prices were modest while the turmoil was contained to Tunisia and Egypt. But now that the turmoil has spread to Libya, a significant oil producer, and Bahrain, a modest energy producer that is however home to the chief U.S. naval base in the region and strategically located between Saudi Arabia and Iran, the risk is rising of a further spike in oil prices driven by a pure “fear premium”—let alone actual threats to the production and transport of oil.

Worst-case scenarios aside, such as the establishment of pro-Iranian or radical Islamist states in these places, at this point, the ouster of regimes in Jordan, Algeria, Yemen or Iran would represent such a rise of the political risk in the Middle East that oil prices could rise significantly.

Of course, in the medium term, even vehemently Islamist regimes—like the one that seized power in Iran in 1979—would produce and sell oil and energy and thus not represent a permanent constraint on oil supplies. And compared with 2008, when oil prices spiked and spare oil production capacity was limited, there is still significant spare capacity today, especially in Saudi Arabia.

But in the short term, oil prices have spiked to much higher levels because of various risk factors:

• a fear premium as a result of the politically contagious nature of the uprisings, even if supplies of oil are not actually hampered;
• the risk that the toppling regimes in oil/energy producing countries may curtail actual production and/or its transport as ongoing political and economic turmoil restrains production (Egypt, Libya, Bahrain, Algeria, Iran);
• the tail risk that the turmoil may eventually spread to affect Saudi oil production as most Saudi oil is in the Eastern Province, mostly populated by restive Shiites close to their revolting brethren in Bahrain;
• the risk that the flight of foreign firms—BP, ENI, etc. —would have a significant adverse effect on Foreign Direct Investment (FDI) in energy-producing economies in the Middle East;
• the risk that unstable political transitions might lead to economic and financial instability that in turn would lead to under-investment in new energy producing capacity;
• the risk that final users and investors in oil might hoard greater oil inventories in a precautionary stockpiling move.

The Middle East holds about two-thirds of the world’s proven oil reserves and almost half of its gas reserves.

Thus, geopolitical risk in the Middle East is a source of spikes in oil prices that have global consequences. Indeed, three of the past five global recessions have been triggered by a Middle East geopolitical shock that propelled oil prices skyward. And in the other two global recessions—2001 and 2008—a rise in oil prices also played a role.

The Yom Kippur War of 1973 triggered a sharp increase in oil prices that led to the global stagflation—recession cum inflation—of 1974-75.

 The Iranian revolution in 1979 led to a similar stagflationary increase in oil prices that triggered the 1980 recession (a double-dip recession in the U.S. in 1980 and 1982).

The Iraqi invasion of Kuwait in August 1990 drove up oil prices at a time when the U.S. banking crisis (the S&L) was already tipping the U.S. into a recession; right after that spike in oil prices, the U.S. and most advanced economies entered a short recession that lasted until the spring of 1991, when the Gulf War ended with Kuwait’s liberation.

 Even in the 2001 global recession—triggered by the bust of the tech bubble—oil prices played a modest role as the onset of the second Palestinian intifada and overall Middle East tensions led to a modest but significant increase in oil prices.

Oil prices also played a role in the most recent global recession.

 The U.S. entered recession in December 2007 following the subprime bust, but the recession became global in the fall of 2008. This global recession was not only triggered by the collateral damage from Lehman’s bankruptcy. By the summer of 2008, oil prices had doubled in about 12 months, reaching a peak of US$148 a barrel. That was a massive negative terms of trade and real income shock, not just for the U.S., most of Europe and Japan, but also for China and all the other net oil/energy-importing emerging markets. This spike in oil prices tipped an already fragile global economy buffeted by financial shocks into an outright global recession.

An obvious place such developments would be felt is in global equity pricing, where a rise in risk aversion/a fear premium associated with a stagflationary oil shock would shake investors’ confidence even before the stagflationary effects of the shock hit economic growth and corporate profits. The stagflationary shock would hit the UK and the periphery of the eurozone hard before it hits the U.S. as growth is already anemic or negative in these economies; but U.S. equities would be vulnerable as well. That said, if the entire region becomes destabilized, there will almost certainly be a flight to quality/safety toward the U.S. dollar and Treasury. Equities would certainly underperform Treasury again.