Iran, Oil Prices, and the Global Economy

Originally published by the Carnegie Endowment for International Peace
Participants: Jörg Decressin, Karim Sadjadpour, Jamie Webster, Uri Dadush

Tensions over Iran’s nuclear program continue to fester, unsettling oil markets, raising prices, and adding uncertainty to fragile global economic prospects. Jorg Decressin of the International Monetary Fund, Jamie Webster of PFC Energy, and Carnegie’s Karim Sadjadpour discussed the likelihood of a military attack on Iran, the impact of sanctions, and the macroeconomic implications of high oil prices. Carnegie’s Uri Dadush moderated the discussion.

Iran’s Position and Sanctions

Iran is showing some signs of softening, but it is unlikely that a meaningful deal will be reached, said Sadjadpour.

• Signs of Conciliation: While the Iranian regime has long been averse to compromise under pressure, Iran is beginning to show signs of conciliation. This is due to unprecedented international political and economic coercion in the form of central bank sanctions and a looming EU oil embargo, said Sadjadpour.
• Concerns of Strike Diminished: Concerns of an Israeli military attack on Iran has diminished significantly over the last several weeks, noted Sadjadpour. As a result, the risk premium on the oil market has come down, but it has also diminished the sense of urgency by Russia and China to keep on the same page with the European Union and the United States regarding sanctions.
• Strait of Hormutz: Sadjadpour likened the closing of the Strait of Hormuz for Iran to a suicide bombing: they would hurt others, but they would hurt themselves the most. Webster added that closing the strait would invite a multilateral response that would be devastating to Iran.
• Unlikely Deal: Election-year politics in the United States make it difficult for the Obama administration to offer concessions, argued Sadjadpour. Moreover, Iran may not be ready to agree a deal, such as capping uranium enrichment at 5 percent, in order to stave off the looming oil embargo.
• Sanctions: While there has been a discernible deterioration of the quality of life due to sanctions, people in Iran overwhelmingly attribute economic weaknesses to mismanagement by the government, both political and economic, including corruption, added Sadjadpour.

Oil Market

Although oil prices have shown some decline recently, they will remain elevated, predicted Webster.

• Oil Price Spike: Sanctions and the risks posed to oil supply by war are the major reasons behind the rise in oil prices before they reversed their upward trend last month, said Webster.
• Recent Decline: Webster noted that oversupply of oil, the potential for some sort of breakthrough, and weaker global economic indicators have precipitated the oil price decline over the past few weeks.
• Prices Will Remain Elevated: Oil prices are unlikely to decline below $80 per barrel, predicted Webster. Rising target prices by oil exporters and stock building by Asian buyers will keep prices up around $100 per barrel, added Webster. Decressin argued that strong growth in emerging economies, where growth is energy intensive, is also a key factor that will keep prices high going forward.

Impact on the Global Economy

Decressin discussed five factors that contributed to the fact that high oil prices in the 2000s did not have a strong negative effect on the global economy.

• Declining Oil Intensity: The oil intensity of production in advanced economies― half of what it was in the 1980s― and key emerging economies has declined a lot since the 1980s.
• Origin of High Prices: High oil prices were the consequence of strong demand, mainly from emerging economies, rather than the supply shocks that tend to do more damage to the global economy.
• Recycling of Petrodollars: Recycling of oil revenues by oil-exporting countries into international markets has supported low interest rates and more investment in the global economy.
• Improved Labor Markets: Unlike the 1980s, labor unions don’t push for wage hikes in response to high oil prices, limiting the impact on employment and output.
• Improved Central Banks: Improved operation of central banks has enabled them to shelter their economies from high oil prices by keeping interest rates low. In previous oil price hikes in the 1970s and 1980s, monetary tightening exacerbated the impact on the global economy.

The global economy’s resilience in the face of high oil prices gives some cause for optimism about further increases in oil prices, suggested Decressin. He argued that, for example, the impact of an Iran-related oil supply shock (or full disruption with no offset elsewhere, which could cause oil prices to rise by 20-30 percent) can be managed by the global economy. However, the effects could be much larger if the tensions were accompanied by significant financial volatility and loss in confidence.

Decressin concluded by warning that the world should still be worried about high oil prices, given the fragile recoveries in advanced economies and consequences of oil price fluctuations on the world’s poor. Moreover, oil supply responds sluggishly to price changes as a result of limited investment in oil production, high cost of oil extraction, and tight environmental regulations.