Another week, another false all-clear.
The Strait of Hormuz remains closed. It appears increasingly obvious that the 20 percent of world oil supply that normally flows through it to world markets won’t be restored to normal anytime in the near future — quite possibly for many months. What will this disruption do to the world economy?
The International Monetary Fund raised the economic anxiety level last week with a projection of a global slowdown “in the shadow of war.” Yet while the IMF brings great expertise to this subject, I think that it is seriously underestimating how badly the global economy could be hit. In my view, a full-on global recession is more likely than not if the Strait remains closed for, say, another three months, which seems all too possible.
Why do I think most forecasts are insufficiently alarmist? Because I believe that most economists are thinking about the Hormuz crisis the wrong way.
The usual approach, which appears to be how the IMF is making its projection, is to start with a guesstimate of the price of oil over the next year, then try to model the effects of that oil price trajectory on the world economy.
An immediate problem with this approach is that, as I argued a few weeks ago, there’s a huge range of uncertainty about the future price of oil if the war goes on, reflecting underlying uncertainty about both the severity of the disruption and the responsiveness of demand to prices. The following table shows various scenarios for the price of oil depending upon the level of disruption of supplies (low, medium or high disruption) and the responsiveness of demand to price (high, medium or low responsiveness). As you can see below, there is a wide range of price scenarios, from $99/bbl to $372/bbl:
More generally, I would argue that the usual approach to modeling the effects of the Hormuz crisis goes about it the wrong way around. We should start with the physical supply constraints, not a guess about oil prices. One way or another, the world will have to burn significantly less oil in the near future than it would have if this war had been avoided. In the jargon of energy analysts, there will have to be large “demand destruction.” But how can oil demand be destroyed? Three ways:
· People can switch away from oil to other energy sources. But there’s very little ability to do that in the short run
· People can switch away from economic activities that use a lot of oil — e.g., they can take buses rather than driving. But for many, perhaps most, people, this option is very limited. For example, there are no buses in American suburbs and there is no substitute for oil to power emerging-market trucks.
· People can just do less overall — consume less, produce less. That is, we can reduce oil consumption by having a global slump. And demand destruction through a global slump can happen quickly.
What about the price of oil? In the face of a major loss in supply it must rise enough to cause an equal destruction of demand. Because there’s very limited ability to reduce the demand for oil through options 1 and 2 above, it appears inevitable that some (if not most) of the demand destruction required will happen through a global recession.
Indeed, as I’ll show in a minute, in past world oil crises a significant share of the demand destruction needed to match reduced supply was indeed “achieved” by having a global recession.
So if your guess about the world price of oil in the face of a large disruption of oil supply doesn’t look high enough to cause a global slump, you’re projecting too low a price.
What does history tell us?
The closest parallel I know to the Hormuz crisis is the oil shock that followed the 1973 Yom Kippur War. (The 1979 Iran crisis was more complex, involving a lot of speculative price changes.) World oil supply fell only moderately after 1973, but it had been on a rapidly rising trend until then, so there was a large shortfall relative to that trend. In the chart below I show the natural log of world oil consumption with 1965 as the base year:
The percentage difference between two numbers is approximately the difference in their natural logs times 100. So this chart shows that the world was burning approximately 17.5 percent less oil in 1975 than it would have under the pre-1973 trend — a supply shock not too different from what we will see now if the Strait remains closed.
What happened to global economic growth? It also fell substantially relative to the pre-1973 trend — a shortfall of roughly 7.5 percent:
A comparable slowdown now would mean zero or negative world growth over the next two years, compared with the current IMF forecast of 3 percent. This would be a true global disaster.
OK, before everyone jumps off ledges, there are large potential mitigating factors this time around. First and foremost is the likelihood that a deal to reopen the Strait will in fact be struck. Basically, the U.S. can get the Strait reopened by loudly proclaiming victory while quietly accepting de facto defeat. All this will take is for Trump to accept reality, admittedly a hard climb.
Even if the Strait remains closed, the world economy is far less dependent on oil than it was in 1973. Here’s an index of world “oil intensity” — barrels of oil consumed per dollar of real GDP — with 1973=100:
This will reduce the impact of higher oil prices on world production — although the remaining oil demand may be less “compressible” than demand in 1973. So reducing consumption in the short run may be harder today than it was in the 1970s.
Finally, beyond the short run there are far more alternatives to oil now than there were in 1973. Given time — even a year or two — the world could make major shifts to other energy sources.
Despite these caveats, however, I would argue that most analysts are still far too sanguine about the effects of a prolonged Hormuz crisis. I don’t know how high the price of oil will go if the Strait remains closed, but it will, more or less by definition, have to go high enough to be seriously destructive.
MUSICAL CODA