The energy economics

With the conflict in the Middle East in its third week the risks to the global economy are mounting. Financial markets, however, are not yet flashing red. US equities have fallen by 4% since the start of hostilities on 28 February, a relatively modest decline by historical standards and just one-third the drop that was seen within four days of Donald Trump’s initial tariff announcement in April 2025. Futures markets assume oil will drop back to around $75 per barrel by the end of the year. The gold price, which has almost doubled in the last two years on geopolitical uncertainty, has edged lower in the last fortnight.

Despite the risks, markets aren’t panicking yet, and with reason. Real energy prices are lower than in 2022, following the invasion of Ukraine, or indeed during the oil shocks of 1973, 1980 and 1990. Growth in US energy output and renewables has reduced the world’s reliance on Middle Eastern oil. Energy is used far more efficiently than in the past. And, unlike the 1970s, consumer nations have petroleum reserves that can be used to protect against shortages and dampen sharp increases in prices.

None of this detracts from the risks posed by a prolonged war. Middle Eastern energy may play a lesser role in the world economy, but it is still vital. The breadth of the conflict, with energy facilities across the Gulf at risk and the Strait of Hormuz virtually closed, is unprecedented. Drones have transformed the nature of warfare, giving Iran a weapon that is hard for adversaries to suppress, and that can be produced cheaply and at volume.

Past energy shocks have contributed to major economic downturns, but they have rarely been the sole cause. The invasion of Ukraine, and the ensuing energy shock, coincided with and reinforced the inflationary effects of the post-COVID surge in economic activity. The first Gulf War in 1990 sent energy prices skyrocketing, adding to already significant domestic inflationary pressures, pushing the US and the EU into recession.

The inflationary backdrop today is less threatening. Unemployment is rising in most western countries, putting downward pressure on wage growth. US activity has slowed in the last two years and the big problem for Europe is too little, not too much growth. Higher energy prices are always bad news for inflation, but the West isn’t dealing with the powerful homegrown inflation it was in 2022 at the time of the invasion of Ukraine.

The domestic strains today lie elsewhere, in financial markets.

Problems have started to pop up in private credit markets, with rising loan defaults and the prospect of significant refinancing this year. After the financial crisis banks pulled back from riskier areas of lending, helping fuel a boom in direct lending to smaller and medium-sized businesses in the US and Europe by specialist funds. Unlike bank loans or corporate bonds, private credit is largely opaque, making it more difficult to assess the scale of the risks. The other obvious vulnerability relates to lofty tech valuations predicated on the as yet unproven promise of AI.

Most problems in the financial sector, such as the blow-up in US regional banks in 2023, tend to be localised, manageable and transient. Big, systemic financial crises, are rare. Nonetheless, conflict in the Middle East, high and volatile energy prices and risks in the domestic financial system make for a challenging backdrop.

A period of elevated energy prices, for a month or two, with oil at $100 per barrel, would probably be manageable for the global economy. If oil got too much over $120 and threatened to stay there, the risks would mount significantly. Pressure on governments would also increase, perhaps leading to the provision of energy subsidies, as were deployed in 2022 – or, possibly, forcing a political resolution to the conflict.

The big surge in US inflation, especially in energy prices, in 2021–22, inflicted real political damage on the Biden administration. With the midterm elections just under eight months off, it’s a lesson that won’t be lost on Mr Trump.