Standard & Poor's examines four possible outcomes and how they would affect economic growth, consumer spending, inflation, unemployment, and other indicators
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From Standard & Poor's RatingsDirect
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 U.S.-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 since Israel began targeting Lebanon. The outcome is now even more uncertain than it appeared 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. With Iranian President Mahmoud Ahmadinejad saying on July 25 that the fighting could trigger "a hurricane" of broader war in the Middle East, the prospects look dire to many observers—especially oil traders—around the world.
Having survived higher energy prices relatively unscathed so far, the U.S. economy is more sensitive to costlier oil now than it was a year ago. Inflation, even excluding energy, has accelerated, leading the Federal Reserve to raise interest rates 425 basis points in response. Consumers are already spending more than they earn. And Standard &Poor's expects the economy to slow down to 2.5% growth in gross domestic product in 2007 from an estimated 3.5% in 2006.
UNCERTAINTY PREVAILS. The falloff in U.S. growth means it takes a smaller shock to cause a recession than it did a year ago. Continued strong world oil demand, with usage in both China and Europe accelerating, will continue to put rising pressure on oil supplies despite a U.S. slowdown, thus raising the odds of an oil price surge causing a U.S. recession.
Whether the current Mideast conflict causes a recession depends mostly on how big the impact on oil supplies and prices becomes. 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. (Of course, there are other, non-military factors—like hurricanes or production disruptions on the order of BP's [BP] Aug. 6 closure of its Prudhoe Bay field in Alaska—that could have an effect as well [see BusinessWeek.com, 8/7/06, BP's Pipeline Trouble].)
The range of worse outcomes, unfortunately, is almost unlimited. We've looked at four scenarios, but even worse cases, or combinations of the problems below, are also possible:
1. Conflict contained Our base case assumes that the fighting is limited to Israel, Gaza, and Lebanon. There is no impact on oil supplies, and prices drop slowly from current levels, which have a risk premium built into them. Oil falls below $70 per barrel by yearend and to $60 per barrel by the end of 2008. The world economy continues to expand, with the U.S. slowing to 2.5% growth in 2007 from 3.5% in 2005 and 2006 but with Europe speeding up this year and Asia remaining solid. Headline inflation rates drop because of the decline in oil prices.
Scenario 1
2004
2005
2006
2007
2008
Real GDP (% chg.)
4.5
3.5
3.5
2.5
2.9
Consumer spending (% chg.)
3.7
3.5
3.1
2.7
3.0
CPI (% chg.)
2.7
3.4
3.3
2.1
1.7
Core CPI (% chg.)
1.8
2.2
2.5
2.4
2.1
Oil price (WTI) ($/barrel)
41.5
56.6
68.0
65.5
61.8
Unemployment rate (%)
5.5
5.1
4.7
4.8
4.9
S&P 500 index
1131
1207
1296
1352
1447
2. Iran shuts its taps In the second scenario, Iran stops exporting oil. This could be in response to a strike on its nuclear facilities, a retaliation against the West for supporting Israel, or internal disruption in Iran. In any case, Iran takes its 2.7 million barrels of oil exports off the market. World oil prices soar, probably to above $100 per barrel temporarily but settling near $95 per barrel. Near the end of next year, oil prices begin to decline, presumably as Iran returns to world markets, and fall back to $66 per barrel by the end of 2008.
This scenario's impact on the U.S. is substantial, with a near-recession starting in the fourth quarter and continuing through mid-2007. Higher oil prices take 1.8% off the level of real GDP by the third quarter of next year and add 3.3% to the level of the consumer price index a year later.
The impact on the euro zone economies is smaller than in U.S., with real GDP cut by a maximum of 1.0% and the CPI up 2.0%. The Japanese price effect is similar to Europe's, but GDP is cut 1.2% because of the greater reliance on oil and on imports.
Scenario 2
2004
2005
2006
2007
2008
Real GDP (% chg.)
4.4
3.5
3.1
1.1
3.2
Consumer spending (% chg.)
3.7
3.5
2.8
0.7
2.1
CPI (% chg.)
2.7
3.4
3.7
4.1
2.5
Core CPI (% chg.)
1.8
2.2
2.6
3.4
3.4
Oil price (WTI) ($/barrel)
42.2
56.6
75.7
95.6
78.2
Unemployment rate (%)
5.5
5.1
4.7
5.5
5.6
S&P 500 index
1125
1207
1219
1018
1310
3. The Gulf goes dry In this scenario, Iran closes the Strait of Hormuz to oil tankers. Oil prices spike sharply. World oil supplies would be cut by about 20%. World strategic petroleum reserves are tapped extensively, but even so, oil prices rise to $250 per barrel. The world economy moves into recession, on the order of the 1980-1982 downturn. The U.S. is the hardest hit of the major economies, with real GDP dropping 5.2% below the baseline in late 2007, implying a major recession, and the unemployment rate reaching 7%. Consumer price inflation hits 10% next year as oil prices soar. The impact on Europe is smaller, but because the Continent started with weaker growth, the recession is just as big. Japan has a recession of similar size.
Both in terms of the price effect and the supply impact, the models are being pushed well outside their historical range, and the dislocations could be even more painful than this projection implies. This is by no means a worst-case scenario but closer to a best case given the closure of the Strait. We think (and certainly hope) this is an unlikely scenario.
Scenario 3
2004
2005
2006
2007
2008
Real GDP (% chg.)
4.5
3.5
2.7
(1.6)
4.0
Consumer spending (% chg.)
3.7
3.5
2.0
(2.5)
2.7
CPI (% chg.)
2.7
3.4
4.1
9.6
0.2
Core CPI (% chg.)
1.8
2.2
2.6
4.2
4.1
Oil price (WTI) ($/barrel)
41.0
56.6
91.7
238.2
106.9
Unemployment rate (%)
5.5
5.1
4.9
6.7
7.0
S&P 500 index
1133
1207
1218
793
965
4. The U.S. gets cut off The fourth scenario involves an oil embargo against the U.S. begun by Iran but then accepted by the other Arab nations, perhaps because the threat of closing Hormuz brings them into line. Without cooperation from other oil-exporting nations, the impact would be minor because the U.S. gets only about 17% of its oil from the Middle East. We assume, however, that Venezuela goes along, thus increasing pressure on the U.S. The embargo will prove leaky because once oil flows onto the ocean, it will go wherever the money is. Also, we would expect most of the embargoing countries to be reluctant to enforce the ban strictly.
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 $90 per barrel for a short while, but we would expect them to come back fairly quickly to the world level, which is essentially unchanged from the baseline. Only a small price differential would exist in the longer run.
The other economies would be slightly hurt because of the weaker U.S. economy and consequent loss of exports. However, the impact would be attenuated because the U.S. slips only slightly from the baseline projection.
Again, worse cases than any of these are entirely possible, with resulting impacts on the U.S. and world economy that are nearly impossible to model. The best hope is for a diplomatic breakthrough—and a little luck — to help limit the outcome to Scenario One.
Scenario 4
2004
2005
2006
2007
2008
Real GDP (% chg.)
4.5
3.5
3.1
1.5
3.1
Consumer spending (% chg.)
3.7
3.5
2.8
1.1
2.2
CPI (% chg.)
2.7
3.4
3.7
3.2
2.1
Core CPI (% chg.)
1.8
2.2
2.6
3.3
3.0
Oil price (WTI) ($/barrel)
41.0
56.6
75.4
75.3
62.3
Unemployment rate (%)
5.5
5.1
4.7
5.3
5.4
S&P 500 index
1133
1207
1248
1118
1358
Wyss is chief economist for Standard & Poor's in New York
All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is or will be, directly or indirectly related to the specific recommendations or views expressed in this research report. Standard & Poor's Regulatory Disclosure
Any advice, analysis, or recommendations contained in articles labeled "Insight from Standard & Poor's" reflect the views of Standard & Poor's, which operates separately from and independently of BusinessWeek Online. It is possible that BWOL may from time to time publish information that is not consistent with advice, analysis, or recommendations that are published by Standard & Poor's. Standard & Poor's and BusinessWeek Online are each units of The McGraw-Hill Companies, Inc.
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