The global economy's jugular

The risk of major disruption to the global oil supply may be increasing.

Introduction

As regular readers of The Global Lead may know, I am a guest editor of the subscriber access only journal Arab Digest. Over the past few days the pages of the latter have featured an exchange about the risk of disruption to the flow of oil through the Strait of Hormuz, a subject on which I touched in my 30 December Outlook 2018 article looking at potentially systemic political risks to the global economy. In this article, I look to summarise some of the key points which emerged in this exchange at a time when it appears that the risk of disruption may be increasing.

A vital artery

To say that the free flow of oil (and gas) through the Strait of Hormuz is critical to the wellbeing of the global economy is no overstatement. In the article which kicked off the exchange, Middle East expert (and my former colleague at the UK’s Foreign & Commonwealth Office) Greg Shapland wrote as follows:

“The Strait of Hormuz is between 35 and 60 miles (55 and 95 kms) wide. It is bordered to the north by Iran and to the south by the Musandam Peninsula, an outlying part of Oman. The Strait is the only maritime exit from the Gulf. Vessels passing through the Strait use a two-mile-wide shipping lane that is recognized by the International Maritime Organization. Seven countries border the Gulf, namely, Iran, Iraq, Saudi Arabia, Kuwait, Bahrain, Qatar, the UAE and Oman. These countries contain 47% of the world’s oil reserves and 42% of its gas reserves; they are responsible for 32% of the world’s oil and 17% of its gas production. Qatar is the world’s largest exporter of LNG (liquified natural gas). While some of this oil and gas is consumed locally, the bulk is exported, and a small proportion of that which is exported goes via pipelines to the Red and Mediterranean Seas and the Gulf of Oman rather than through the Strait of Hormuz. The bottom line, however, is that a great deal of the energy which powers the global economy – including about 35% of all seaborne oil exports and over 30% of the global trade in LNG – has to pass through the Strait. Much of the Gulf states’ trade in other commodities does so, too: for example, over a third of Iran’s non-oil trade passed through the port of Bandar Abbas, on the northern shore of the Strait, during the Iranian year 2016-17.”

Could Iran close the Strait?

Mr Shapland’s main focus was to consider whether Iran’s Islamic Revolutionary Guard Corps (IRGC) would — or, indeed, could — deliver on its periodic threats to close the Strait if tensions in the Gulf region increase still further. His conclusion — shared by most, if not all, experts — is that to do so for more than a very brief period of time would be remarkably difficult, if not impossible. Nevertheless, Mr Shapland warns that the IRGC could well be tempted to increase its harassment of ships, including US warships, in the Strait, thereby increasing the risk of precipitating a US military response and consequent further escalation. As he concludes: “It is in such miscalculation that the greater danger to shipping in the Strait seems to lie”. My personal view, based in part on what actually happened at the start of the Iran/Iraq war in 1980, is that this alone could cause a sharp enough surge in the price of oil to damage the real economy globally and roil financial markets to the point of further damage. Furthermore, this could be sustained if, as former UK defence attaché in Riyadh Brian Lees pointed out in the Arab Digest exchange, insurers elected to cancel policies on shipping entering the Strait, as we have seen happen at times of heightened risk in the past.

A Trump trigger?

Commenting on Mr Shapland’s article, I wrote as follows (with some additional references hyperlinked for the purposes of this article):

“…in addition to the possibility of Iran pursuing actions which may put the flow of oil through the Strait at risk, I think we should take a step back to consider the possibility that Washington, rather than Tehran, could ‘start something’ which would take us in this direction.

Last August, top psephologist Nate Silver, writing about Donald Trump’s obsession with his own approval ratings, opined that the US President was probably quite capable of launching a ‘wag the dog’-type event to give himself a booster in the run-up to the 2020 general election, or even the 2018 mid-terms if the GOP was languishing in the polls to the point where its majorities were at risk (as appears to be the case in the House despite the narrowing of ‘generic’ polls in the wake of the passing of the tax bill). [Mr] Silver had in mind some sort of military operation against North Korea.

I would not personally rule this out, ‘inconceivable’ (to quote, of all people, Steve Bannon) though it may seem to many. But I do wonder if Iran is at least as likely, if not more likely, a target.

Spurred on by the Saudis, the Israelis and, no doubt, his son-in-law [Jared Kushner], [Mr] Trump has promoted Iran to US enemy No 1 in the Middle East following the demise of IS’s caliphate and...seems determined to torpedo the Joint Comprehensive Plan of Action (JCPOA), by declining to renew the sanctions waiver which will be on his desk again in the first half of May. Furthermore, although he continues to defend the JCPOA per se, let’s keep in mind that Defence Secretary James Mattis is about as hawkish as they come when Iran is the issue; and that [Mr] Trump is very likely to recall how a cruise missile attack on one of Bashar al Assad’s airfields last year bumped up his ratings.

If [Mr] Trump were, say, to order a cruise missile strike against some element of Iran’s missile programme to give Tehran the ‘bloody nose’ which the Pentagon talks of openly now in the context of Pyongyang, it is very unlikely to cause the Iranians to moderate their regional ambitions and/or stop testing missiles (two of [Mr] Trump’s specific bugbears); indeed, quite the contrary as the US’s reneging on the JCPOA would undoubtedly strengthen the hardliners in Tehran (at the expense of [Iranian] President [Hassan] Rouhani), potentially giving them more room to push back against the US.

Furthermore, it is very open to question whether Iran would take such a blow lying down. Which takes us firmly to [Mr Shapland’s] musing about the possibility of the IRGC trying to threaten the flow of oil through the Strait. But it may yet be the US, rather than Iran, which is effectively behind the deepening of the existing crisis in the region, at least in the first instance.”

Regional expert James Spencer followed up with some thoughts (with which I concur) on how Iran might retaliate. Citing a couple of historical examples, he suggested that any Iranian retaliation would likely be proportionate. For example, if an Iranian missile base was attacked, retaliation could take the form of a ballistic missile strike on one of the recently revealed ‘secret’ US military bases in the region. This certainly seems to me to be an option; but it is also one which would almost certainly lead to a further escalation which would likely add a perceived political risk premium to the price of oil even if there was no obvious immediate threat to the flow of oil through the Strait of Hormuz.

Will Bibi ‘wag the dog’?

Meanwhile, another former British diplomat, Sir Oliver Miles, also responding to my comment, offered the thought that: “If one is looking for a flesh-creeping scenario [Tel Aviv] is perhaps even more convincing than Washington”. He was, of course, referring to the deepening travails of Israel’s Prime Minister Benjamin ‘Bibi’ Netanyahu and wondering whether he might be tempted into ‘wag the dog’ action to distract from the allegations against him. That any such action could be directed against Iran (even though other ‘targets’ involving less risk, such as Hamas, are clearly available) seems to me to be a perfectly legitimate concern given the recent escalation in hostilities around the Golan Heights and growing evidence of some sort of alliance between Israel and a number of Arab countries (notably Saudi Arabia, the UAE and Egypt) against Iran. Sir Oliver concludes as follows:

“Israel might calculate that direct military action against Iran would win friends in Washington, Riyadh and Abu Dhabi. Israel would not be immune to the damage that even very short-term closure of the Straits of Hormuz would do to the world economy, but (unlike Washington, Riyadh, Abu Dhabi and much of the rest of the world) has no direct stake in trade through the Straits.”

To this I would add that, with US domestic oil production now standing at over 10mbpd and rising, Mr Trump, whose thinking on economics is not always ‘conventional’, may reckon that increased oil prices may not be such a bad thing for the US economy. Furthermore, it may also appeal to Mr Trump that China would take serious knock from the disruption of oil and gas supplies from the Gulf given that East Asia buys 85% of its exports (and I doubt he would be too concerned over similar blows to US allies Japan and South Korea).

If not today…

All this being said, having risen to over USD70pb in January for the first time since 2014, Brent crude, the global benchmark, is ‘languishing’ below US$63 this morning, which strongly suggests little or no investor concern over a possible supply side shock. Given that, despite all the turmoil in the Middle East, we have seen virtually zero evidence of perceived political risk around the oil price since mid-2014 (at least until Saudi Arabia’s Crown Prince Muhammad bin Salman triggered some concerns late last year), this is not really surprising. Furthermore, it may even be justified. After all, Mr Trump will probably not move against Iran until May; and in Israel the attorney general’s office could take months to decide whether to Mr Netanyahu should face charges. Nevertheless, I see Mr Shapland’s article as a timely reminder that there are already real risks around the flow of oil through the Strait of Hormuz; and that those risks may well increase in the immediate future.

Alastair Newton

A footnote to my own article. My friend, sometime client and former colleague Paul Schulte of California-based Schulte Research wrote to me last evening to say he had just finished watching Homeland Series 6 (just out on DVD and I haven't got hold of a copy yet). He tells me one of the storylines involves the US getting effectively conned into war with Iran by Israel. Well, would you rule it out in real life?