Is A Big Oil Shock Coming This Fall?

An unnamed “decision-maker” – presumed to be Ehud Barak, the defence minister – told the Haaretz newspaper that Israel could not afford to wait for the US to act. “We need to look at the reality right now with total clarity,” he said. “Israel is strong and Israel is responsible, and Israel will do what it has to do.”
If so, the three months before the US presidential election in November provide the obvious window for an Israeli strike. The impression given is that the world may be a few weeks away from another war. As for the possible consequences, Israel’s outgoing civil defence minister says that any conflict would take place “on a number of fronts”, lasting for 30 days and costing about 500 Israeli lives.
--Daily Telegraph, Aug. 16th, 2012

Since 9/11 and the Lehman crisis, we have been advised to be on the lookout for economic “black swans”, meaning unexpected events of large magnitude*. One particular swan has been flapping around our heads with increasing urgency these days, namely the Israeli government’s hints that it intends to attack Iran this fall.

Without getting into motives and probabilities, let’s assume that this will happen. Let’s also assume that a Gulf War III will close the Persian Gulf for a considerable period of time. Iran can keep the Gulf closed indefinitely, since marine insurers won’t cover war risks in a war zone. Iran herself can’t export under such a scenario, but that could be a secondary consideration in the eyes of an angry people.

As we know, the short-term demand curve for oil is price-inelastic, because the ratio of stored oil to daily consumption is low. The world economy is designed around the presumption that the oil pumps are on all the time; there are no readily-available inexpensive substitutes in the short-to-medium term. Therefore, in the event of another oil shock, the price mechanism would have to be used to bring oil consumption down by 25% almost immediately. The price of oil will be set at the margin by those who must have it, can’t produce it, and can afford it at any price. Bad news for the emerging markets, and really bad news for Greece.

How high would the oil price have to go to cut consumption by 25% overnight? High enough to force oil-dependent countries to ration electricity and gasoline. We’ve been there twice before in 1973-74 and again in 1979-80. Remember long lines to get gas at the pump?

This would be the world’s third oil shock, and its impact might be similar to the prior ones. In the seventies, central banks sought to cushion the shocks resulting in considerable inflation, then pulled back hard in 1980-82 causing high interest rates and a global recession in 1982-83.

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An oil shock, possibly combined with the fiscal cliff or an explosion in the eurozone, would produce a sharp drop in aggregate demand, necessitating QE3 or QE4. The Fed would be hard-pressed to fully compensate for the decline in confidence and consumption. Europe would be hit even harder because it would start from a weaker position and it has a central bank asleep at the switch.

I find it hard to imagine that Gulf War III would be a brief and uneventful exercise. It would almost inevitably be a big event on the scale of the prior Gulf wars, maybe even bigger. These wars tend to escalate, and given the potential involvement of the Gulf states, this one could be the biggest of all. Also, Iran may prove a more formidable opponent than Iraq.

The risk of Gulf War III simply adds another event to the black swan list: (1) eurozone explosion; (2) the fiscal cliff; and now (3) another war. Let’s hope that all three don’t happen at once. If they do, I feel sorry for the guy who wins in November.
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* Wikipedia: The black swan theory is a metaphor that describes an event that is a surprise, has a major impact, and after the fact is often inappropriately rationalized with the benefit of hindsight.
The theory was developed by Nassim Nicholas Taleb to explain:
The disproportionate role of high-impact, hard-to-predict, and rare events that are beyond the realm of normal expectations in history, science, finance and technology
The non-computability of the probability of the consequential rare events using scientific methods (owing to the very nature of small probabilities)
The psychological biases that make people individually and collectively blind to uncertainty and unaware of the massive role of the rare event in historical affairs

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