How war in the Middle East could derail the global economy

What was he thinking?

When US President Joe Biden last Thursday casually dropped that he had discussed military strikes against Iran’s oil export facilities with Israel, all hell broke loose.

Crude oil prices, which in recent months have been languishing, immediately took flight, surging 5 per cent. By the end of the week, they had stacked on 8 per cent.

It didn’t take long for the inevitable about face. By Friday, Biden had canned the idea, saying he had warned Israel against it and ordered it to find “other alternatives”.

There’s no doubt an attack on Iran’s oil export facilities would hurt. The country has been crippled by sanctions for years and oil is its main source of income.

But an Israeli attack could backfire for America at precisely the wrong time and forever taint any legacy that Joe Biden may want to leave.

With an election looming, the Democratic Party’s chances of re-election have been boosted by an almost miraculous turn of events.

The US has just declared victory from a bruising two year battle with inflation, giving the US Federal Reserve the leeway to last month slash interest rates by 0.5 percentage points.

More cuts are scheduled in coming months, even as unemployment remains historically low with solid jobs growth.

Should Israel attack Iranian oil export facilities, however, analysts believe oil could surge almost 40 per cent, back towards $US100 a barrel, potentially igniting another bout of inflation.

Such a move would rule out any further chance of interest rate cuts, here and the rest of the world, possibly plunge America and the globe into recession and kill any chance of Kamala Harris becoming America’s first female president.

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Iran oiling China’s machinery

Should it be tempted, Israel’s main target would be Kharg Island, 50 kilometres off the Iranian coast in the Persian Gulf, and home to the country’s biggest export terminal.

On Sunday, Iranian Oil Minister Mohsen Paknejad felt safe enough to visit the island and meet with employees and naval personnel.

“We are not afraid that our enemies will ignite a crisis, and visiting the region is a normal business trip,” he told state television.

Iran has been steadily increasing its influence over global oil supply.

While it is a member of the Organisation for Petroleum Exporting Countries, it is not bound by the export and production quotas set by the cartel.

Sanctions imposed by then US president Donald Trump in 2018 over its nuclear program initially hurt the Iranian economy and it has been looking for ways to skirt the sanctions ever since.

It now produces around 3 per cent of global output after lifting output faster than any other OPEC member in recent years and exports this year have reached multi-year highs.

Most of its oil lands in China although it claims to ship oil to as many as 17 countries, many of them surreptitiously. China’s other main source of oil is Russia, also subject to sanctions since its invasion of Ukraine.

While Iran does not supply fuel to the West, at least in any great volume, taking out Kharg Island would have an immediate impact on global supplies as China would need to source replacement oil elsewhere.

China most likely would lean on Russia for extra supplies, thereby limiting the fallout.

The biggest fear, however, would be the threat of the unknown; as such an attack would heighten tensions and perhaps encourage attacks on other fields.

How does all this impact Australia?

As a major energy exporter, higher prices benefit us as a nation. Gas and coal prices generally rise as oil prices lift, companies earn bigger profits and pay more tax which lifts our national wealth.

The downside, however, is that fuel is a component in almost everything we consume, from food and shelter to clothes and chemicals.

That adds directly to the cost of production of almost everything, including the gear we import, which then forces prices higher.

A major spike in the cost of fuel would be enough to scare the Reserve Bank of Australia on potential rate cuts.

As the graph below illustrates, oil prices quickly recovered from pandemic lows as the global economy kicked back into gear. It was the Ukraine invasion that caused a major reshuffle of European markets, especially for gas, that sent inflation soaring, peaking in Australia at 7.8 per cent.

Oil did it last time and could be the catalyst again.

The good news on oil is that, until last week, prices have been steadily declining since their Ukraine invasion peak and until a few weeks ago, were at their lowest levels in three years and only slightly above pre-pandemic levels.

Prices briefly dropped below $US70 a barrel in September with OPEC seeing little scope for improvement given the sluggish global economy. China’s economic woes, in particular, weighed down expectations.

That’s been evident in petrol prices at the bowser. Prices have declined significantly in recent months and were expected to drop to as low as $1.65 a litre.

That now appears to have been derailed as the conflict has escalated and as a massive new wave of Chinese government economic stimulus has boosted commodity prices.

RBA may be forced to wait

It’s been a hard slog for the Reserve Bank of Australia to ratchet down inflation.

When the Consumer Price Index for the all-important September quarter is released in a few weeks, many were hoping lower fuel costs would be a major contributing factor to further undercutting prices.

The June quarter showed inflation still uncomfortably high at 3.8 per cent but the low monthly numbers since have lifted calls for rate cuts within the next few months.

While that remains the hope, there’s no doubt the RBA will have a sharp eye on the future.

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The greater the risk of a widening regional confrontation and the potential for another oil inspired lift in inflation could be enough for it to keep rates on hold for longer than would have been otherwise expected.

Estimates on the timing of a rate cut had narrowed in recent weeks. Some believe it could be late this year, to deliver some welcome relief to the battered retail sector in the lead up to Christmas. Most expected the first cut early in the New Year.

Either way, it was down to a couple of weeks.

But as the military action has spread from Gaza to Lebanon and now to Iran, and the potential that may have to destabilise the global economy, the RBA is more likely to exercise caution rather than risk cutting rates just as an inflationary pulse courses through the global economy.

Joe Biden’s interventions so far have done little to help alleviate the suffering and incredible loss of life in the Middle East during the past year. In his final few weeks in office, focusing on containment rather than escalation would be a welcome development.