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The historical implications of a sudden surge in oil prices

Impacts of minimal disturbances in Middle Eastern production on the global market are expected to be manageable.

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Potential consequences from minor disruptions in Middle Eastern energy production may be limited.
Potential consequences from minor disruptions in Middle Eastern energy production may be limited.

The historical implications of a sudden surge in oil prices

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The Israel-Iran conflict serves as the latest geopolitical risk to keep investors on their toes. But unlike past issues, this isn't about American tariffs or awkward diplomacy in the White House. Instead, we're looking at an old-school conflict threat to global oil supplies.

Oil prices surged by a whopping 12% in response to Israel's bombing of Iran's nuclear facilities. Over the weekend, the conflict intensified, with Israel targeting a major oil terminal in Tehran. Iran pumps around 3.3 million barrels of crude per day, with 2 million being exported. With global oil demand estimated at 103.9 million bpd by the International Energy Agency, a severe Iranian production disruption might seem daunting. However, Saudi Arabia and the UAE reportedly have the ability to quickly produce an additional 3.5 million bpd, so even a significant disruption in Iran may be manageable.

The dance between geopolitical uncertainty, oil prices, and macroeconomics is rarely simple. A fascinating study published by the European Central Bank in 2023 provides some insight. It revealed that immediately after the 9/11 attacks, Brent crude prices rose by 5% due to fears of war and potential oil supply disruptions in the Middle East. But within 14 days, prices had dropped by 25% as concerns about a slowing global economy and weakened oil demand emerged. After Russia's invasion of Ukraine in February 2022, Brent prices skyrocketed by 30%. However, they returned to their pre-invasion levels eight weeks later.

This years-long research suggests that geopolitical shocks mainly impact the global economy through two channels. In the short term, the risk channel is the most significant. market uncertainty about potential supply disruptions causes an increase in the value of holding oil contracts, known as the convenience yield, which drives up oil prices. However, in the long term, the economic activity channel comes into play. Higher geopolitical tensions usually act as a negative shock to global demand, as increased uncertainty wears on investment, consumption, and trade. This channel generally dampens global oil demand and prices. In other words, oil price pressures from geopolitical shocks tend to be temporary.

Yet, not every geopolitical shock has been short-lived. The oil price shocks of 1973 and 1979 were both followed by U.S. recessions, and the prospect of a geopolitically driven oil price spike still causes concerns for policymakers and investors. They may find some comfort in research published earlier this year by the Federal Reserve Bank of Dallas. The study's authors attempted to separate out oil price uncertainty from other forms of economic uncertainty. They discovered that geopolitically-driven oil price risks are unlikely to cause significant recessionary effects. Even a massive increase in the risk of a production shortfall similar to the 1973 or 1979 incidents would, according to the model, lower economic output by only 0.12%.

While uncertainty about future oil supplies can elevate crude prices temporarily, the global macroeconomic fallout is likely to be minimal unless the risks materialize. Similarly, asset prices may drop in response to geopolitical events but usually recover quickly. The Iraq-Kuwait invasion and Russia's invasion of Ukraine had a brief impact on global equity markets, but 1973 stands out as an exception, with global equity markets remaining significantly lower 12 months later due to the oil embargo.

So, while the duration and escalation of the Israel-Iran conflict remains to be seen, it's essential to remember that, even during the Tanker War of the 1980s, when over 200 oil tankers passing through the Strait of Hormuz were bombed, oil prices eventually stabilized after an initial spike. Short of a major disruption in Middle Eastern oil output, the effects are likely to be contained.

  1. The escalating Israel-Iran conflict could potentially impact various markets, particularly the business and finance sectors, given the vulnerability of global oil supplies.
  2. The energy industry, specifically the oil-and-gas sector, might experience significant fluctuations due to geopolitical risks, as demonstrated by the surge in oil prices following Israel's bombing of Iran's nuclear facilities.
  3. Investors should keep a close eye on the economy, as the ongoing Israel-Iran conflict could have long-term effects on investment, consumption, and trade, impacting macroeconomics.
  4. Amidst the Israel-Iran conflict, policymakers and investors may find some assurance in research suggesting that, while geopolitically-driven oil price risks can cause temporary price spikes, their overall impact on the economy is likely to be minimal unless the risks materialize.

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