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Looking down the barrel: S&P's impact analysis of Mid East conflictnews
08 August 2006
Mumbai: If anything underscores how geopolitical forces have played havoc with oil prices, it's the latest armed conflict in the Middle East, pitting the Israeli military against Hezbollah guerrillas in open warfare in Lebanon. Already heightened by the US-led confrontation with Iran over its nuclear ambitions, fears about the stability of oil supplies have only increased since the Gaza bombings earlier in July and have intensified sharply as Israel targets Lebanon.

When it comes to oil consumption as a share of GDP, the US is at about the global average. An oil price hike will generally affect Europe less because the continent uses less energy relative to GDP. Japan will be affected more than Europe because it imports almost all its energy, while in Europe and the US a high percentage is domestically produced.

China could feel the biggest impact because it has a slightly higher ratio of energy use to GDP than the US and imports more of its energy. On the other hand, higher energy prices will help Russia and other oil producers. Russia's economy is already benefiting from the increased price of oil and natural gas.

Although the US economy has been able to absorb higher energy prices so far, it has become more sensitive to costlier oil now than it was a year ago, according to a report published by Standard & Poor's Ratings Services.

Titled Conflict In The Mideast: Four Oil Supply Scenarios, says that any major disruption on oil supplies, particularly in the Middle East region, could have an impact on the US and global economy.

Standard & Poor's expects the economy to slow down to a 2.5 per cent GDP growth pace in 2007 from an estimated 3.5 per cent in 2006, and the falloff in US growth means it takes a smaller shock to cause a recession than it did a year ago.

"Whether the current Mid East conflict causes a recession depends mostly on how big the impact on oil supplies and prices becomes," explained Standard & Poor's chief economist David Wyss. "But this is still highly uncertain. At Standard & Poor's, we continue to believe that the most likely outcome is that cooler heads will eventually prevail and that oil prices will drop back from current peaks."

The outcome is now even more uncertain than it appeared to be just a few weeks ago. How long the conflict continues - and whether it spreads to surrounding countries - will determine the future of energy prices, at least in the short run. Standard & Poor's examined four different scenarios, but even worse cases--or combinations of the problems described below--are possible. The four scenarios are:

The conflict is contained. The current fighting subsides without spreading to Syria or Iran but is limited to Israel, Palestine, and Lebanon. Oil prices subside to $70 / barrel by year-end. The world economy continues to expand, with the US slowing to 2.5 per cent growth in 2007 from 3.5 per cent in 2005 and 2006 but with Europe speeding up this year and Asia remaining solid. Headline inflation rates drop because of the decline in oil prices.

Iran shuts its taps. The conflict spreads to Iran, perhaps because of air strikes by Israel or the US on nuclear or other facilities. Iran stops exporting oil. However, the Strait of Hormuz, through which most Persian Gulf oil flows, remains open, and Arab states continue to export. If Iran stops exporting oil, OPEC might be able to make up 1 million barrels, but its production is already near maximum. The world and U.S. strategic petroleum reserves (SPRs) can be drawn upon, but that would leave countries completely vulnerable if the conflict spreads further.

World oil prices soar, probably to above $100 / barrel temporarily but settling near $95 / barrel. Near the end of next year, oil prices begin to decline, presumably as Iran returns to world markets, and fall back to $66 / barrel by the end of 2008

The Gulf goes dry. As in the second scenario, except that Iran partially closes The Strait of Hormuz. Most Persian Gulf oil shipments are shut down for a period of six months before the vital shipping lane reopens. World oil supplies would be cut by about 20%. Oil prices rise to $250 / barrel.

The world economy moves into recession, on the order of the 1980-1982 downturn. The U.S. is the hardest hit of the major economies, with real GDP dropping 5.2% below the baseline in late 2007. Europe and Japan face similar recession.

The US gets cut off. The Persian Gulf countries join in a selective embargo of the US, refusing to export oil to the world's biggest energy consumer but continuing to supply it at similar volume to Asia, Europe, and other oil-importing regions. Venezuela cooperates with the Arab embargo.

The embargo may prove leaky because once oil flows onto the ocean, it will go wherever the money is. Still, as in 1973, such an embargo could create significant short-term problems for the economy and the U.S. oil market.

Prices would probably peak above $90 / barrel for a short while, but we would expect them to come back fairly quickly to the world level and only a small price differential would exist in the longer run.

Global economies would be slightly hurt because of the weaker US economy and consequent loss of exports.

"Standard & Poor's base case assumes that the fighting is limited to Israel, Palestine, and Lebanon," Wyss added. "There is no impact on oil supplies, and prices drop slowly from current levels, which have a risk premium built into them."

"Again, worse cases than any of these are entirely possible, with resulting impacts on the U.S. and world economy that are nearly impossible to model. The best hope is for a diplomatic breakthrough - and a little luck - to help limit the outcome to the first scenario," Wyss concluded.


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Looking down the barrel: S&P's impact analysis of Mid East conflict