An oil shock is coming – but it might be the last
A possible war in the Middle East and the rise of renewables could make old energy forms obsolete
Outright war is again about to descend on the Middle East – that much is obvious. When was the Middle East ever not at war, you might ask? But what’s coming looks to be very much more serious than the largely intra-national civil conflicts seen in recent years; a war that pits Israel, Saudi Arabia and the United Arab Emirates, backed by the US, on the one hand against Iran, possibly backed by Russia, on the other.
Rarely have the stars been so uniformly aligned for this longgestating conflict. With Donald Trump in the White House, surrounded by known Middle East hawks such as national security adviser John Bolton, and Mike Pompeo, Secretary of State, it gives Israel and Saudi Arabia the opportunity they have long sought permanently to degrade Iran’s regional ambitions, and contain them accordingly. If they don’t seize it now, it may be many years before it presents again. As if firing the starting gun, Mr Pompeo this week issued a blistering series of demands of Iran, which with presumably intentional irony he described as “very basic requirements” and “not unreasonable”. Yet to Tehran, they seemed to amount to a demand for unconditional surrender, or essentially giving up the country’s sovereign right to defend itself. It is as if the US wants to be rejected, and it makes the slide to war seem almost inevitable. Crippling sanctions are not where this ends.
And yet surprisingly, this likelihood is not yet much reflected in financial markets, where a relatively buoyant global economy is causing share prices regularly to hit new highs. There is one market, however, where the steady beat of war drums is heard loud and clear – oil. Since late last year, the price has risen by a third to nearly $80 a barrel – the 11th-largest oil price spike in 70 years, according to data compiled by UBS. Its impact is already being felt at the pumps.
That’s not all down to Middle East tensions; it’s also about upward pressure on demand from a growing global economy, agreement in Opec to curb supply and economic collapse in Venezuela, which has severely affected that country’s production.
Yet the possibility of Middle Eastern war is already very much in the mix, and in the event of outright hostilities the price would skyrocket to $100 and beyond. Saudi Arabia could theoretically compensate for the loss of Iranian production by boosting its own supply. Yet if the effect of war is to disrupt shipments through the Strait of Hormuz, then it may be in no position to do so. Besides, Saudi is by no means averse to the current upward trajectory; it needs an $80- plus oil price just to break even fiscally on current expenditures. On the other side of the fence, an economically struggling Russia would also very much welcome a much higher oil price.
Fortunately, the world economy is no longer as sensitive to oil price shocks as it used to be. Oil intensity in the global economy – the amount of oil needed to produce a single unit of output – has long been in steep decline, having fallen by more than half in advanced economies since the 1960s.
What is more, all those warnings of “peak oil” – the idea that the oil would run out before alternatives are found – have turned out to be so much poppycock. The shale revolution has created an abundance of supply, such that peak world demand for oil will be reached – probably about 15 years from now – long before the reserves begin to dwindle. The rapid advance of renewables makes it highly likely that a large part of these reserves will never be used at all.
Happily, the shale revolution has in any case transformed the world’s largest economy, the US, into a net beneficiary of a high oil price, a complete reversal of the position it has found itself in during previous oil price spikes. The world over, economies are weaning themselves off oil.
Even so, oil still has the power to shock. The macroeconomic impact of a rising oil price is both inflationary and deflationary at the same time. It raises general price inflation, and, by taking money out of consumers’ pockets, depresses wider economic demand. As a general rule of thumb, a 10 per cent rise in the oil price knocks about 0.1 per cent off global output. It doesn’t sound much, and certainly the price would need to rise a lot to in itself derail the current global recovery. Nonetheless, combined with the knock to confidence from an all embracing Middle East conflict, the effect would be quite bad enough, especially on oil-poor regions such as China.
Yet there is also a longer-term bonus to be had from higher oil prices, the effect of which is to incentivise the development and production of alternative sources of energy. These are coming on in leaps and bounds, such that some of them are already cheaper than traditional hydrocarbons. We are at a tipping point, where the march of renewables starts to render older forms of energy production obsolete.
Oil producers should enjoy the price spike while it lasts. They’ve got a few decades left in them yet, but this may be their last hurrah.