Energy prices surge

Talk of recession is back. Last Friday Qatar's energy minister, Saad Al-Kaabi, forecast that Gulf energy exporters would shut down production within days and that the oil price could hit $150 per barrel. The conflict in the Middle East, he warned, could "bring down the economies of the world".

Energy prices have surged since the start of hostilities, with European gas prices closing up almost 60% last week and the price of Brent crude up 25%. Early trading in Asia suggests that oil prices will rise sharply in Europe and the US today.

Prices are below levels reached in 2022, after Russia’s invasion of Ukraine, but we are only nine days into a conflict that, according to the US administration, could last for several weeks. As happened in 2022, prolonged uncertainty could push energy prices higher still. Russia attacked Ukraine on 24 February 2022, but oil prices did not reach a peak until June, more than three months later.

Surging oil and gas prices are harbingers of economic trouble. Higher energy prices, triggered by war or revolution in the Middle East, were major factors in western recessions in 1973, 1979 and 1990. The surge in energy prices in the wake of Russia’s invasion of Ukraine collapsed Europe’s growth rate in 2023.

Today’s conflict has led to a falling away of traffic through the Strait of Hormuz, the narrow channel between Iran and the Arabian Peninsula through which about 20% of the world’s oil and gas is shipped, mostly to Asia. The risk of Iranian drone or missile attacks has made it impossible, or hugely expensive, for ships to obtain war risk insurance. Iran has repeatedly threatened shipping in the Strait in the last 45 years but has never achieved such a level of disruption as is being seen today.

This conflict differs from last June’s 12-day war between Iran and Israel in another important respect. Iran has extended its attacks from US military bases and Israel to the whole region including the UAE, Kuwait, Qatar and Saudi Arabia. This spells a far higher risk of damage to crucial oil and gas facilities than in last year’s conflict.

In some respects the world is better placed to deal with disruption to oil supply than in the past.

Energy markets are more efficient, integrated and contestable than they were in the 1970s. Shale fracking has led to a surge in US energy production, weakening OPEC and reducing the role of the Middle East in energy supply. In the late 1970s about 60% of the global oil supply went through the Strait of Hormuz. Today it accounts for 20% of supply. Consumer nations now have petroleum reserves that can be used to protect against shortages (though US reserves are at low levels). Oil’s share of global energy supply has fallen as a result of greater efficiency in consumption and countries switching to renewables. Global GDP is less oil-dependent than in the past.

In the last nine days financial markets have priced in higher inflation and interest rates and weaker growth. The real question is whether these shifts will be enough to tip economies into the sort of downturns Europe saw after the invasion of Ukraine or outright recessions.

So far it looks likely to be something milder.

Last week the UK’s National Institute of Economic and Social Research forecast that if the oil price were to hit $100 per barrel and stay there for 12 months UK inflation this year would be 0.7% higher – a rate of 3.2% rather than 2.5% – and growth would be 0.2% lower – 0.8% rather than 1.0%. These are non-trivial, but manageable, changes.

The actual effects on the global economy will depend on the duration of the conflict and the scale of disruption to energy shipments.

Much hinges on the arithmetic of drone and missile production, launches and interception. Jack Watling of the Royal United Services Institute notes that scale is everything in drone warfare: Russia, for instance, launched 75 drones against a Ukrainian anti-missile battery of which 73 were intercepted. The two that weren’t destroyed the battery. The UK think tank, the Centre for Information Resilience, estimates that Iran has the industrial capacity to produce around 10,000 drones per month. Protecting energy infrastructure – and everything else – depends on suppressing Iranian drone and missile output and intercepting them once in flight. Given that drones are smaller, cheaper and simpler to produce in volume than missiles, the threat from the former may prove more lasting.

For now financial markets are not pricing sustained economic disruption. Futures markets show oil prices easing next month and beyond. The decline in the UK equity market, with the FTSE 100 index down 6% from its 27 February peak, is not suggestive of a material downturn in corporate prospects. But as long as the conflict continues, the risk of serious economic damage grows.