Impact of higher oil prices

Since Israel and the U.S. attacked Iran, the pressure on oil supply from the Middle East has increased. As a result, oil prices hit their highest level in nearly four years amid energy disruptions, and history holds some clues about how that will impact markets and the economy. Brent crude oil jumped above the $100 mark and continues to edge up. It is the highest oil has been in nearly four years, since shortly after Russia invaded Ukraine. The oil-price spike driven by the war in Iran has already been a major shock to markets, with stocks tumbling and stagflation forecasts percolating on Wall Street.

There are correlations with inflation and oil during other economic crises, such as the 2008 downturn and the covid-era economic slump. Yet the main thing to watch for is the persistence of the increase. Only large and long-lasting spikes in oil prices, a supply shock, seem to be a leading indicator for a persistent increase in inflation. The duration risk rises the longer the Strait of Hormuz remains closed, flagging three key risks from higher energy prices.

First is the risk that high-income consumer spending weakens in the event of a stock market sell-off. The K-shaped economy is being propped up by high earners’ robust spending, as equities trade near record highs and compound the wealth effect. The second risk is weaker spending by lower-income households. Lower-income people are more exposed to oil shocks and higher energy prices could translate into rising credit delinquencies. Finally, AI capex bottlenecks pose another key risk. Delayed investment because of high energy prices could be a headwind for GDP growth this year.

It is difficult to assess exactly how large and persistent the oil price shock would have to be for these effects to kick in. A sustained period of oil prices above $100/bbl (~60% increase) would probably take more than 60bp off GDP growth. And a doubling in oil prices, unlikely as it seems, could cause a recession.

There is also a list of winners by higher oil prices. The main winners are the parts of the economy that produce, transport, or finance oil and gas such as companies that extract crude oil from the ground. Their costs change slowly, but the price they sell oil for rises immediately, so profits jump, for example ExxonMobil, Chevron and Shell. Higher crude prices directly increase revenue and profits for these upstream companies. This is also the case for oil-exporting countries such as Saudi Arabia, Russia and Norway. Higher oil prices can help fund government spending and reduce deficits in these economies. When oil becomes expensive, producers start drilling more wells because more projects become profitable, in particular if the higher price level is expected to last. Firms that transport or store oil also benefit because higher prices and geopolitical tensions increase demand for secure supply chains, for example pipeline operators, oil tanker companies and LNG exporters. Oil spikes often come with geopolitical tension, which can boost commodity producers, defense companies, and shipping/logistics firms.

There is no precedent for the surging price of oil, as the Middle East crisis deepens fears of prolonged production shut-ins and disruption to shipments through the strategically vital Strait of Hormuz. The effective closure of the Strait of Hormuz is something energy markets had never seen before. Unless something changes very soon there could be a potentially game-changing and unprecedented energy crisis. Countries across the oil-rich Middle East region have started to scale back crude output. Iraq and Kuwait have already begun to shut-in production, and the United Arab Emirates and Saudi Arabia may also be vulnerable if the Strait of Hormuz remains closed for a sustained period. Typically, about 20% of the world’s oil and gas passes through the Strait of Hormuz, but shipping traffic has all but halted through this key maritime corridor since the war started. Finance ministers from G7 economies would hold an emergency meeting this week to discuss a possible joint release of petroleum from reserves coordinated by the IEA.

As the conflict is not likely to end any time soon unless Iran decides that their best open is unconditional surrender and start working to form a new government under U.S. supervision, the oil price can continue to increase. As Iran is getting weaker each day as they will run out of missiles, get their leaders killed and eventually be unable to defend themselves, there is also eventually an end to the war. Should Iran get a reasonable government, this might change the dynamic of the region and it can expand financially and oil prices will then stabilize as a result. This will likely take a few more weeks and even longer, so for now, oil prices will continue to be on the rise and there will be winners and losers.