The war in Gaza, oil prices and the global economy

Introduction

Since Hamas’ attack on Israel on October 7th and the subsequent land incursions of the Jewish State in the Gaza Strip, the war in the Middle East, which cost the life to many, has been at the centre of the geopolitical scene. After almost two months of bloody combat, we take a step back and try to answer questions about the consequences of that fatal day. Our focus will particularly be on the oil market, how oil prices have changed and might change in the near future and why this is of interest to the global economy.

Where was the oil market standing before 7th October?

Before delving into the most recent developments, it may be useful to touch upon the main features of the oil market before the outset of the war. OPEC, an economic cartel gathering oil producing countries that coordinate in the determination of prices and production, accounted for more than 41% of global oil production in 2019 (1). Among its members are Saudi Arabia (which produces 9m barrels per day), Iran, United Arab Emirates, Kuwait, and Venezuela (all around 3m barrels per day). Russia – that is not an OPEC country but part of the so-called OPEC+ alliance – produces more than 10m barrels per day (slightly less than what was estimated before the war in Ukraine started). The biggest producer worldwide is the United States, which is expected to reach an all-time high of 19m barrels per day in 2023. Finally, Chinese, and European crude supply represents respectively 4.3% and 3.3% of the total (2).

In the last 3 years, the oil market has been shaped by many unexpected events. At the beginning of this decade, the COVID pandemic caused both a collapse in demand and disruptions in the global supply chain. Prices fell dramatically (even turning negative on 21st April 2020) and the pre-pandemic equilibrium was reached again only at the beginning of 2021 (3). The slow price recovery that followed was suddenly accelerated by the outbreak of the war in Ukraine. Futures on West Texas Intermediate (WTI, the US crude oil price benchmark) surged above $120 per barrel for the first time in 8 years. After another peak in June 2022, the trend started to revert, since the omen of big reductions in Russia’s exports did not materialise, and the appealing high prices led other countries to increase their own production. The steady fall in prices (i.e., the shrinking revenues, on which they are greatly dependent) alerted some big oil producers. Concrete action was taken by Saudi Arabia and Russia in April 2023, when the two reached an agreement to cut their production by 1 million barrels a day by the following month (4). However, they failed to cause excess demand in the market because, in the meantime, the supply of the USA and other countries was rising. Hence, a second agreement on a further cut of 1.3 million barrels per day was signed. The effects of this pact combined with the surge in Chinese demand after the Covid restrictions were lifted, finally resulted in a demand exceeding supply by 2.2 million barrels a day in the third quarter of 2023. Thus, prices spiked and hit a 13-month high of almost $94 per barrel in late September 2023 (5). 

7th October

It was in this context of high prices that, following the events of 7th October, Brent crude (the main European oil contract) and US WTI (the main US oil contract) prices reached respectively 88.82$ and 87.05$ p.b., an immediate increase of approximately 5% (6). Initial fears of a further escalation in the region led analysts and traders to expect prices to mount above the $100 threshold. However, after a peak on 20th October, crude prices begun to fall, down to the minimum since the start of the war of $73.09 p.b. (WTI, 16th November) (7).

Why did prices not soar instead? 

To begin with, the war has not caused any disruption to oil supply so far, and traders are not willing to increase prices before “actual barrels [are] removed” from the market, as Mr. Raad Alkadiri (managing director for energy and climate at Eurasia Group) put it (8). This is mainly because Israel produces little oil, and the Gaza Strip does not produce any. However, the geographical setting needs to be taken into account. Indeed, what may cause disruptions in the oil supply is an expansion of the war to other Middle East countries, which, account for almost a third of global oil production (9). 

Based on these considerations, right after the 7th of October, the three possible scenarios about the effects of the war on oil prices sketched out by Larry Elliot on The Guardian were (10): 

  1. The war remains circumscribed to Israel and Hamas. In this case, after a period at hold around $93 per barrel the price of crude oil should soon decrease. As noted, prices are now fluctuating around a significantly lower range of values;
  2. Other countries in the region, such as Iran, Syria or Egypt, join in. This may result in major shocks to the supply chain, which would in turn make crude prices rise, possibly up to $150 p.b.;
  3. China takes advantage of the situation and imposes a blockade on Taiwan and the once regional conflict precipitates into a cross-regional (potentially global) one. The consequences for global supply chain, asset prices and markets’ uncertainty would be as hard to predict as unequivocally ruinous.

How does oil price matter?

The Centre on Global Energy Policy (CEGP) (11) defines oil intensity as “the volume of oil consumed per unit of gross domestic product (GDP)”. It represents the importance of oil for a society. Since 1973, oil intensity has decreased by 56%, showing a steady linear fall starting from 1984. Moreover, “as the energy transition gathers pace”, global oil demand growth is expected to slow down in the future years (12). Why should we be concerned about the effects of the war on oil prices, then? Global oil demand has increased from 2379 million tonnes in 1971 to 4070 million tonnes in 2020 and it is expected to reach its peak only in 2028 (13). This means that oil is still highly relevant in the world and that it matters for transportation, energy and inflation (among others). Let’s examine this last remark.

As everyone can easily observe, the price of oil has direct effects on the price of fuels, influencing transportation costs. The U.S. Bureau of Labor Statistics tracks the evolution of prices through the Consumer Price Index (CPI), i.e. a “weighted average of prices for a basket of goods and services representative of aggregate U.S. consumer spending” (14). Energy accounts for 7,185% of the basket of consumption considered for the October 2023 estimate and in particular energy commodities account for slightly less than 4%. On these claims, an increase in oil prices should cause an almost 1-to-1 rise. However, this is not the whole story. Some petrochemicals used for the production of plastic are obtained from oil and this creates an indirect link between its price and inflation, faced mainly by goods producers. Indeed, the Federal Reserve Bank of St. Louis found that the Producer Price Index and oil prices have a correlation of 0.71, while the correlation between oil prices and the CPI is 0.27. This difference is due to the substantial relevance of services (less reliant on oil-related inputs) for the bundle of consumption taken into account for the determination of the CPI, making producer price more prone to oil price oscillations (15). Additionally, the FED chairman stated in 2022 that a $10 p.b. rise in the price of oil leads to a 0.2% increase in inflation and a 0.1% fall in growth, as a rule of thumb (16). 

Having established that oil prices affect the inflation rate; we should turn to another question: is inflation bad for the economy? Inflation erodes people’s savings and, to the extent that wages don’t adjust immediately, real incomes. However, recent studies show that the effects of inflation on real standards of living are quite limited, particularly if it is in single digits. Nevertheless, high inflation has a psychological cost – as the majority of people sees it as highly detrimental to them – and may lead agents to anchor their future inflation expectations to higher values, making it harder for central banks to fight the price hikes (17). Higher inflation expectations make producers and workers revise prices and wages upward, thus fulfilling the expectations themselves. This creates a suitable environment for inflation to become persistent and, possibly, to run out of monetary policy’s control (18). Central banks then would probably be forced to tighten monetary policy to avoid run-up inflation and to bolster their credibility (which, in turn, is key for expectations formation) (19), which would further restrain economic activity, possibly originating a recession. For instance, the Yom Kippur War provoked a troublesome period for Western countries, haunted by stagflation (20). Thus, we can conclude that oil prices do affect the global economy, and are, hence, worth studying also for the outsiders of the energy market. Then, let us complete our initial analysis. 

Effects on the global economy

Based on the war’s future developments, the repercussions on the world economy may vary widely. 

If the conflict were to remain circumscribed to Israel and Hamas, crude prices should stabilise around (or even below) $80 per barrel, having little or no effect on the world economy. 

Instead, what rises concerns, notwithstanding the doomsday scenario of point 3) above, is the possibility that the war expanded to other regional powers. For instance, if Iran entered the war on Hamas’ side, the USA may react by tightening sanctions on the Persian country, reducing Iran’s oil supply by 1m barrel per day with a one in four probability. This would bring crude prices to $140 p.b. by next year. An additional cause of preoccupation is the fate of the Strait of Hormuz, through which more than 20% of oil consumed globally transits. Although deemed unlikely, the closure of the Strait by Iran would prevent Qatar’s oil from shipping to Europe and the US. The European Union, since the reduction of imports from Russia, is highly reliant on Qatar as a supplier and in 2022 purchased 16% of Qatari production. Supply disruptions would result in higher prices, which would benefit oil producers in the short run. However, perduring high prices would eventually make demand shrink, harming the producers themselves. To avoid this, Saudi Arabia may backtrack and start producing more, violating the agreement with Russia. Moreover, the USA and other countries have been injecting more and more oil in the market since 2020, and if this trend is confirmed they will pose a concrete threat to the market power that OPEC+ enjoys at the moment. In such a complex framework, opposing interests collide: as the Kremlin needs high prices to attain rich revenues to sustain the military expenses in Ukraine, Joe Biden will hardly be re-elected if he fails to tame prices. (21)

Conclusion

As the conflict in the Gaza Strip is still ongoing, it is hard – if not impossible – to predict how it will resolve and how deeply it will impact the world; geopolitically and economic-wise. This article, however incomplete, was aimed at illustrating the possible (many) scenarios concerning the oil market and their effects on oil prices. More importantly, its purpose was to shed light on the reasons why oil prices still matter – whether we like it or not – although some people may see them as outdated or scarcely relevant.

Bibliography:

Vittorio Schivazappa

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