Oil the biggest threat to fragile global economy

TODAY’s fragile global economy faces many risks: the risk of another flare-up of the euro-zone crisis; the risk of a worse than expected slowdown in China; and the risk that economic recovery in the US will fizzle (yet again). But no risk is more serious than that posed by a further spike in oil prices.

The price of a barrel of Brent crude, which was much less than $100 last year, peaked recently at $125. The reason is fear. Not only are oil supplies plentiful, but demand in the US and Europe has been lower.

Simply put, increasing worry about a military conflict between Israel and Iran has created a "fear premium".

The three global recessions preceding the most recent one were each caused by a geopolitical shock in the Middle East that led to a sharp spike in oil prices. The 1973 Yom Kippur War between Israel and the Arab states led to global stagflation in 1974-75. The Iranian revolution in 1979 led to global stagflation in 1980-82. And Iraq’s invasion of Kuwait in 1990 led to the global recession of 1990-91. The most recent global recession, though triggered by a financial crisis, was worsened by spiking oil prices in 2008.

With the barrel price reaching $145 in July of that year, oil-importing economies faced a recessionary tipping point.

The risk that Israel’s threat to attack Iran’s nuclear installations will lead to military conflict may still be low, but it is growing. Israeli Prime Minister Benjamin Netanyahu’s recent visit to the US demonstrated that Israel’s fuse is much shorter than the Americans’. The current war of words is escalating, as is the covert war that Israel and the US are allegedly engaging in with Iran (including killings of nuclear scientists and the use of cyber warfare to damage nuclear facilities).

Iran, with its back to the wall as sanctions bite harder, could react by increasing tensions in the Gulf.

Eventually, it could easily sink a few ships to block the Strait of Hormuz, or unleash its proxies in the region, which include pro-Iranian Shia forces in Iraq, Bahrain, Kuwait and Saudi Arabia, Hezbollah in Lebanon, and Hamas and Islamic Jihad in Gaza.

Recent attacks on Israeli embassies around the world appear to signal Iran’s reaction to the covert war being waged against it, and to the tightened sanctions, which are aggravating the effects of its economic mismanagement. Likewise, the recent escalation in cross-border fighting between Israel and Gaza-based Palestinian militants could be a sign of things to come.

The next few weeks could bring a reduction in tensions, as the US, France, Germany, the UK, China and Russia go through another round of attempts to prevent Iran from developing nuclear weapons or the ability to produce them. But if this attempt fails, one cannot rule out that Israel and the US agree that, sooner rather than later, force will have be used to stop Iran.

Indeed, while Israel and the US still disagree on some points — Israel wants to strike this year; the Obama administration is opposed to military action before facing the voters in November — the two sides are converging on aims and plans. The US is now clearly rejecting containment (accepting a nuclear Iran and using a deterrence strategy). So, if sanctions and negotiations don’t credibly work, the US will have to act militarily against Iran. The US is now providing bunker-buster bombs and refuelling aircraft to Israel, while the two militaries are increasing joint military exercises in case an attack becomes necessary and unavoidable.

If the drums of war grow louder, oil prices could rise in a way that will most likely cause a US and global growth slowdown, and even an outright recession if a military conflict erupts and sends oil prices soaring.

Moreover, broader geopolitical tensions in the Middle East are not fading and might intensify. Aside from deep uncertainty about the course of events in Egypt and Libya, now Syria is on the verge of civil war and radical forces may get the upper hand in Yemen, undermining security in Saudi Arabia. There is still concern about political tensions rising in Bahrain and Saudi Arabia’s oil-rich Eastern Province, and potentially even in Kuwait and Jordan, all areas with substantial Shia populations or other restless groups.

Now that the US has left Iraq, rising tensions between Shia, Sunni and Kurdish factions do not bode well for the country’s ability to boost oil production soon. There is also the continuing Israel-Palestine conflict, tension between Israel and Turkey and hot spots in the wider neighbourhood.

Oil is already more than $100 a barrel, despite weak economic growth in advanced countries and many emerging markets. The fear premium might push prices significantly higher, even if no military conflict takes place, and could trigger a global recession if one does. © Project Syndicate, 2012. www.project-syndicate.org