How Middle East Unrest Could Harm the World Economy

Includes: DBO, GAF, GULF, OIL, USO
by: Rick Newman

For all the drama, the protests roiling Arab capitals have had little impact so far on the global economy. Since demonstrations began in Egypt in mid-January, for example, the S&P 500 has risen a healthy 4% or so. Oil prices briefly drifted above $90 per barrel, but have since settled back below $85. Global investors seem to have the news on, but the sound turned down.

Instability in the Middle East is obviously nothing new, and while turmoil in nations such as Egypt, Bahrain, Iran, Libya, Algeria, and Yemen may set back those economies, a slowdown in regional growth is unlikely to spread elsewhere. The roughly two dozen countries that make up the Middle East and North Africa region—MENA, to economists—account for only about $2.5 trillion in GDP, combined. That's one-fifth the size of the U.S. economy and barely 3 percent of world output.

Oil, however, is a different story, since it can rapidly transmit Middle East turmoil to many other nations. The Middle East accounts for 30 percent of the world's oil production and a bigger portion of proven reserves, and even small changes in the supply of petroleum can have an outsized impact on the oil-thirsty economies of the United States, Europe, and Asia. Research firm Roubini Global Economics points out that three of the last five global recessions have followed some kind of shock in the Middle East that drove oil prices up. "Even regional political turmoil that does not disrupt oil supplies directly can increase prices," writes RGE Chairman Nouriel Roubini in a recent research note. So far, regime change in Tunisia and Egypt and the increasingly violent protests in Bahrain and Yemen have left the oil markets unscathed. But the same types of socioeconomic problems exist in Libya, Algeria, Iran, Saudi Arabia, and other major oil producers, and if Egyptian-style revolution hit any of those countries, it could be a game-changer.

For now, the overthrow of any Persian Gulf oil monarchies seems unlikely, partly because oil-rich nations are somewhat insulated by their own wealth. When the natives get restless in Saudi Arabia or Kuwait, for instance, the government typically boosts the lavish subsidies paid to ordinary citizens, essentially buying their quiescence. Plus, living standards are already much higher in the oil-rich nations than in struggling economies like Egypt or Yemen, where poverty and high unemployment drove protesters into the streets. Still, there's no guarantee that what has worked in the past will keep working. In Bahrain, for instance, the king tried recently to lull protesters by offering every family $2,500 in cash. The protesters only seemed to get angrier. "They're not going to be placated just by money," says Mohsin Khan, a senior fellow at the Peterson Institute for International Economics. "There's something more in the air."

Water-cooler worst-case scenarios focus on a militant takeover of Saudi Arabia or another big oil nation, similar to the 1979 Iranian revolution. But far lesser shocks could also send oil prices skyrocketing, which in turn could be enough to torpedo the fragile economic recovery that's underway in many countries. Libya and Algeria, for instance, control about 4.5 percent of the world's oil production, and rulers in both countries are battling pro-democracy uprisings. If either nation underwent a full-fledged revolution, that wouldn't necessarily mean the oil fields would stop pumping. But there could be sabotage, strikes, or other measures meant to disrupt the flow of oil, and that could be enough to send prices upward. Iran, with about 4.8 percent of the world's oil production, is another obvious wild card. The theocratic, hard-line regime there has been able to squash pro-democracy movements in the past, but its grip on control seems to be under stress once again.

One common assumption is that if political developments impeded the flow of oil in one or two nations, other producers—Saudi Arabia, mostly—would pump more, to make up for it. Roubini estimates that the Saudis have up to four million barrels per day of excess capacity—roughly equivalent to Iran's total production—which seems like a lot of slack in the system. But that doesn't account for the jittery psychology of the oil markets, which at times can be more powerful than the underlying fundamentals.

The world got a primer on that in 2008, when oil prices rose from $95 per barrel to $145 in a mere six months. The causes still aren't completely clear, but it does seem evident that a bubble mentality led traders to bid up oil because they felt prices would go even higher in the future. The bubble burst as the global recession hit, and by the end of 2008, prices had collapsed by nearly 70 percent. On one hand, it's reassuring that oil prices fell back to levels more consistent with real economic activity. But the 2008 spike also revealed the extent to which psychology and fast computerized trading can dominate the market for volatile commodities like oil. "Once there's movement in prices, momentum trading kicks in and people want to lock in future prices," says Khan. "That pushes prices higher and higher. The market can overshoot significantly."

If oil prices could surge by 50 percent in 2008—when the world was sliding into recession and the Middle East seemed a bit calmer than it does now—then another bubble is certainly possible if several Middle Eastern capitals are in a state of rebellion. And one clear lesson of the last few years is that despite the expertise of Ph.D.'s trying to predict every possible development, "externalities" able to shock the global economy can still catch everybody by surprise. So it might not be a challenge to the Saudi monarchy or the Iranian ayatollahs that sets off an oil shock, but a series of smaller triggers that nobody foresees right now. In addition to strikes or sabotage by oil workers, Khan says other indicators to watch for include the departure of foreign engineers or other technical experts who help keep the oil fields pumping in many Gulf states.

The global economy can probably withstand a 10 or 15 percent rise in oil prices, but anything more than that could threaten the recovery. Roubini says that if prices crested $100 and stayed there for a while, it would cut into global consumption and GDP growth, which could lead to a double-dip recession in some countries. If political upheaval actually interrupted the flow of oil, the effect would be more abrupt. Says Kahn:

"It wouldn't have to be a permanent loss of oil. Even a temporary loss over six or 12 months would be enough for prices to rise very rapidly. The impact on the world economy would be significant.

Most economists don't see that happening. Roubini predicts that oil prices will stay around $90 per barrel in 2011; forecasting firm IHS Global Insight predicts prices of $91. And the Saudis have recently suggested they'd pump enough oil to keep prices closer to $80. But those very reassurances from the economic establishment could make price spikes even more destabilizing if something unforeseen happens. It couldn't hurt to turn the sound back up.

Disclosure: No positions

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