How expensive oil could hit the global economy

High oil prices are already hurting the fragile global economy. And the prospect of war with Iran could send the world into a full-blown oil crisis. Matthew Partridge examines what that would mean.

The global economy is already fragile. Britain's economy is flat-lining, while Europe is in recession. China's collapsing property market could hit the rest of the economy hard. And the US while showing signs of improvement remains vulnerable.

Unfortunately, things could be about to get a whole lot worse.

As my colleague David Stevenson pointed out, the risks of war with Iran are increasing. Iran's nuclear programme and its support for Syria's brutal Assad regime is making it a major global threat. Indeed, punters on betting website think that the odds of a US or Israeli strike by the end of the year are better than even.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

If war breaks out, oil prices are likely to soar. Tehran is already cutting supplies to Europe ahead of the July sanctions imposed by the West. Ian Taylor, chief executive of the world's largest independent oil trader Vitol, believes that Brent crude could hit $150 a barrel.

That would be bad news for the global economy, and for us in particular. The sterling price of oil has already hit an all-time record, and it's not far off it measured in euro terms.

Any further gains could create economic chaos here's how.

What happened in the 1970s oil shocks?

In 1973, Arab countries tried to pressurise the US into abandoning Israel by stopping oil exports to Western Europe, America and Japan. Prices quadrupled from $3 to $12 over this period.

Higher production costs led to stagflation (a hugely unpleasant economic condition where both inflation and unemployment rise together, as companies try to cut costs and hard-pressed households cut spending). Attempts to impose price freezes resulted in shortages, which in turn led to rationing. Some industries were particularly badly hit: at one point in 1974, car companies had to leave a fifth of their production capacity idle.

Overall, it would take two years for the US economy to return to the levels of late 1973. A 2008 study estimated that the total lost economic output during this period was equal to 8% of GDP.

Economies and stock markets don't always follow one another but in this case, economic turmoil was matched by market upheaval. The Dow fell from 1,067 at the start of 1973 to 570 at the end of 1974.

The second oil shock

In 1979, the fall of the Shah of Iran disrupted oil supplies, while Iraq's invasion of Iran also caused a fall in both countries' oil output. This caused oil prices to double from 1978 to late 1980.

Again, this hit Western economies hard. US inflation reached an annual rate of 15% in early 1981. Unemployment shot up to 7.6% in the same period. Although strict monetary policy imposed by Federal Reserve chief Paul Volcker - would later bring inflation down, it drove unemployment to a peak of 9.9%.

An oil shock wouldn't hurt as much now but it could still wreak havoc

Europe and America have become better able to deal with rapid increases in the price of oil. Car drivers are more aware of fuel economy, while the economy has moved away from energy-intensive manufacturing. There are also more alternative energy sources than there were in the 1970s.

Yale professor Willem Nordhaus estimates that the 1979-80 oil price spike reduced US growth by 4.3%. Yet the tripling of the oil price between 2001 and 2006 only reduced output by 2.4%.

So our ability to withstand shocks has certainly improved. However, things haven't changed so much since the 1970s that we can just shrug off rising prices. Yes, there are more energy options, but most are either too expensive or viewed as too risky. While shale gas has the potential to lower energy prices overall, its role as a game-changer risks being overhyped.

Governments have also failed to invest in the sort of infrastructure that would genuinely have helped. They have splurged money on 'bridges to nowhere', airports and motorways, rather than mass transit systems. Electric cars such as the Chevy Volt are not viable without subsidies.

The International Monetary Fund has estimated that every $20 rise in the price of oil will lead to a 1% decline in US growth. That's rough and ready, but it suggests that a price of $150 per barrel of Brent a $30 increase would push the US very close to recession.

The effect on emerging market growth might be even worse.Manufacturing-rich and energy-intensive - China would be hit even harder. Rising inflation could force the country to tighten monetary policy, at a time when investors across the world are pinning their hopes on easier money in China.

Oil may go down as well as up

Of course, a spike in crude is only one possible outcome. Saudi Arabia could also boost production to increase the pressure on Iran.

And for all that, Vitol argues that we might see the price rise to $150 -the company still believes that it's more likely that oil will remain around $120. That's still a significant economic burden, of course. But if high oil prices do force an economic slowdown, then that in turn would usually act to push prices lower.

However, it's worth being prepared for the worst outcome, especially given that, assuming you're a British investor, we're already at the mercy of record high oil prices. Making sure you've got some gold in your portfolio is a good option China's fondness for it is unlikely to be diminished, even by a slowing economy.

You can also look at oil companies, and shale in particular. While it may not be a miracle cure, that doesn't mean the companies involved can't profit from the hunt for alternative sources of oil.

Dr Matthew Partridge

Matthew graduated from the University of Durham in 2004; he then gained an MSc, followed by a PhD at the London School of Economics.

He has previously written for a wide range of publications, including the Guardian and the Economist, and also helped to run a newsletter on terrorism. He has spent time at Lehman Brothers, Citigroup and the consultancy Lombard Street Research.

Matthew is the author of Superinvestors: Lessons from the greatest investors in history, published by Harriman House, which has been translated into several languages. His second book, Investing Explained: The Accessible Guide to Building an Investment Portfolio, is published by Kogan Page.

As senior writer, he writes the shares and politics & economics pages, as well as weekly Blowing It and Great Frauds in History columns He also writes a fortnightly reviews page and trading tips, as well as regular cover stories and multi-page investment focus features.

Follow Matthew on Twitter: @DrMatthewPartri