OIL AND INFLATION - THE LONG-TERM IMPACT ON THE ECONOMY - Filenews 14/3
By Michael Lynch
Oil prices fluctuate sharply in reaction to political statements, but the biggest impact on energy will come from military action in Iran and the Middle East in general — and in particular under the threat of tankers in the Strait of Hormuz.
Even if the U.S. declares victory over Iran and stops its attacks, oil exports will be curtailed until it is ensured that the Iranians do not cause disruptions to shipping and the oil supply chain. Prices will fall as soon as the US announces the end of its attacks, but they will not return to pre-war levels until the Iranians stop threatening shipping.
The loss of 20 million barrels of oil a day passing through the Strait of Hormuz is a short-term problem. Some of this oil is being stored and will be available when shipping returns to normality. What is more worrying? Overflowing storage tanks in oil-producing countries mean a halt in production, which cannot be replenished afterwards. If the conflict continues for three weeks or more, the previous global surplus will be depleted, setting a floor on prices, which were expected to fall before the war.
The new oil crisis is reminiscent of the principle of Tolstoy's "Anna Karenina": "All happy families are like each other, every unhappy family is unhappy in its own way."
There is a tendency to think of oil crises as a simple change in the supply/demand balance, especially when politics disrupts supply, with the impact being weighted in terms of barrels. Fortunately, the reality is more complex.
Ignoring for the time being the issue of the psychology of traders and the market and its effect on oil prices, the immediate effects concern the reserves that existed before the limitation of production, the available "reserves" in case of overcapacity (OPEC), the strategic oil reserves (OECD, China and other states) and, above all, the willingness of these countries to use them.
Combined with the climate of uncertainty, the estimates and the psychology of traders, the course of oil prices is difficult to predict accurately, but it will certainly be bullish.
Main Economic Impacts: Inflation and Spending
The main economic impact of an oil crisis can be seen in inflation, consumer income and spending. Higher oil prices lead to an increase in inflation. According to a rule of thumb, every 5% that oil prices gain inflation rises by 0.1%. The 50% rally we're seeing these days will add about 1% to inflation. It may not be an impressive increase, but it is a cause for concern and will certainly make the Federal Reserve more hesitant to cut interest rates further.
On the other hand, the diversion of capital from investment and consumer spending to the oil markets has a significant deflationary effect. Research in the past has shown that doubling oil prices would reduce U.S. GDP by 1 percent, but that figure seems too high today.
In the US, gasoline consumption at 9 million barrels per day is equivalent to about 400 million gallons per day, which means that a price increase of $0.50/gallon costs $200 million per day to consumers.
The amount corresponds to 0.1% of consumer spending, assuming that prices remain stable. It's not excessive, but it will definitely be painful for those who have larger vehicles and make longer trips. Even a small increase in the price of gasoline will have a deflationary impact on much of the US, while the southwestern states will prosper. If gasoline reaches $5/gallon, that equates to nearly 0.5% of consumer spending, a level at which consumers limit optional spending. If the increase at the pump persists, the summer vacation period could prove, at best, anaemic.
Oil consumption in the US amounts to 19 million barrels per day. This means a cost of 1% of GDP if oil prices jump from $60 to $120 per barrel. If the US imported all the oil it consumes, we would be talking about a huge economic blow. As the US is a net exporter, the transport is not from the US to foreign oil producers, but from consumers – individuals and businesses – to producers. This limits economic damage, but does not prevent it.
Spillovers: The general economy
Spillover economic effects emerge as oil price increases affect the overall economy. In addition to higher transportation costs due to the rapid increase in diesel prices, the agricultural sector is about to enter the sowing season and is heavily dependent on diesel for its equipment. The current price increase will add about 2-3 billion dollars in his expenses. Sowing will decrease and food prices will rise within the year.
Airlines will also be hit hard, as jet fuel accounts for 20-30% of their operating costs, and a 50% increase in the price of fuel will wipe out their profits unless they raise ticket prices. However, with the economy weakening, this will be difficult. Even so, higher travel expenses will cut back on vacations this summer, hurting the hospitality sectors.
The dollar is showing signs of resilience, given that the United States, as a net exporter of oil and gas, will suffer less impact than its oil-importing trading partners. This will result in both a reduction in inflation and a reduction in exports outside the energy sector, with a deflationary effect.
Third-degree repercussions
Tertiary impacts are significant, as supply barriers create indirect effects. Past experience of oil crises shows that these can be as important as the primary effects of rising oil prices. A prime example is the Iran oil crisis of 1979-80, during which Canada, a net exporter of oil, entered a recession. This was largely due to the effects of the recession.
Now, if Asian economies, which depend almost entirely on oil imports, sink into recession, then the United States will see its exports decline. And China may try to counter the deflationary effects by increasing its exports, hurting manufacturers and producers around the world.
Finally, the impact of higher and volatile oil prices on business sentiment and consumer confidence could amplify pressures on the economy, increasing the likelihood of a recession. This could be exacerbated by an aggressive stance by the Fed, which responds to the immediate inflationary impact of higher oil prices, ignoring the possibility of the economy weakening in the future.
Much emphasis has been placed on the fact that the U.S. economy did not show the negative effects that many had predicted from last year's tariffs and "trade wars," but this intensifies the uncertainty inherent in a complex economy, rather than excessive pessimism. Most of the effects of higher oil prices will be negative, and the longer the conflict with Iran lasts, the worse it will be.
