Since October 7, many have asked about the economic risks of the escalating and broadening conflict in the Middle East. Beyond the countries immediately involved, the risks that move the global economic needle linked to the global oil and gas balances, and in the last month, shipping costs.
Higher Shipping Costs are Here to Stay, with Europe Most Affected. The Houthi attacks on vessels linked to Israel have prompted many container ships to go on diversion around the horn of Africa – adding significant cost and time to supply chains. Until recently Russian and GCC fuel tankers still traversed the danger zone, as did some Chinese container ships, after making agreements with the Houthis. However following the US/UK/allied strikes, many other countries are avoiding the area. Global shipping prices have gone up as journey times lengthen, due to both the Red Sea diversion and the Panama Canal one. This has come at a time when more fuel is taking longer journeys due to the shift of European imports from pipe to tanker and a reduction in western refinery capacity. These trends coincide with a new round of sanctions enforcement that prompts more scrutiny from insurance and other service providers.
For now, the main losers from the Red Sea diversions are Egypt, which has seen a cut in Suez Canal revenues, Europe where just-in-time imports face longer and more costly journeys and to a lesser extent China and Asian exporters, who have to bear higher costs. Smaller ports and those more northerly may be exposed. It is another relatively blow to European competitiveness as US industrial policy pulls in investments.
Markets still in “show me the lost barrels” mode: Despite an initial concern, oil traders have been relatively nonchalant about the risks and oil prices have generally trended down in the last few months, before stabilizing and modestly rising to $80/barrel in the last week. Are they under-estimating risks? Perhaps, especially now that the conflict is wider, but ample spare capacity, and OPEC struggling to put a floor in the price of crude and rising supplies out of the Americas have helped dampen the price.
What would it take to have a major persistent spike in the oil price? Supply losses from Iran or a major producer such as Saudi Arabia. This could include infrastructure damage or persistent blockage of a major chokepoint like the Strait of Hormuz. A persistent spike in oil prices would require significant and persistent outage, but a temporary outage could leave a lasting premium that modestly increased prices from this level.
Iran: Iranian supplies are at risk from a major reimposition of US sanctions that would take significant volumes of oil offline, stopping China, its only buyer of note from purchasing. But there are limitations in the ability and willingness to do such sanctions enforcement. The development of a whole ecosystem of illicit energy trade over the last several years (due to sanctions) makes it harder to take Iranian supplies offline. This network of shell companies in the UAE and East Asia involves entities that avoid touching the US-based global financial system. Recent US sanctions have modestly tightened conditions and added discounts, but they are likely to do more to avoid new Iranian volumes coming on to the market rather than clawing back 2023 volume increases. Taking significant volumes offline is not impossible but would require significant blunt financial tools that the US seems reluctant to employ at this time, not least because doing so would imply secondary sanctions on Chinese entities including some banks. While the US seems willing to continue with targeted restrictions on high level semiconductors and their equipment with China, and the threat of secondary sanctions associated with Russia’s military supply chains, they may be unwilling to add another grievance to China.
Saudi Arabia in focus: Losses from another major energy producer are also a concern, most notably to one of Iran’s neighbors across the Gulf. Damage to Saudi or Emirati infrastructure would be a concern if the conflict broadens, but this seems less likely given the persistence of the Saudi-Iran agreement which suggests the Houthis will continue to target other entities. Of course in the case of escalating conflict, it is hard to predict. That brings us to the risks in the strait of Hormuz – this chokepoint is much more important for oil markets and would be difficult to block for a long period of time. It is true that in a MENA conflict the fact that ample spare capacity is in the GCC with few others having ability to boost short-term supplies, a fact that could bring back in a geopolitical risk premia in the future. But this could be modest unless actual barrels are kicked offline.
What about inflation? A notable rise in the oil price would undermine the recent disinflation narrative and could delay the timeline of Fed easing, though core inflation and wages are much more important for the Fed’s decisions. A supply shock driven price increase, coming at a time of slowing US growth, is not best fought with monetary tightening. Overall 2024 is likely to be a softer year than 2023 as the impact of past hikes and last year’s tech convulsions bites, but a softer landing still seems more likely than a hard one. I’m more worried about potential fiscal drag and policy shifts post 2025. The current groundhog day on government funding is not great for sentiment, but the big drivers of investment are continuing.
Looking longer-term the conflict is likely to amplify pressure in the global order and increase the voices of key emerging economies who would like a greater say in global governance and global supply chains. The extension of US sanctions to larger and larger targets especially those in China and Russia as well as a recourse to secondary sanctions, is among the reasons increasing the desire, if not the ability to be less reliant on the US dollar. The alignment in the G7 has limited the interest in Euro or other G10 currency as an alternative and the increased use of the RMB is notable, but it is rising from a low base and still subject to ambivalence from Chinese authorities. The dynamics in the region plus the energy demand/price outlook are likely to leave entities like the PIF investing more at home, looking for partnerships and technology transfers in the companies they are investing in abroad. Overall, expect more multiplication of supply chains, aimed at resilience, but presenting new choke points.
Ziemba Insights 