Why I’m watching Saudi Arabia for signs of another economic crisis

War in the Middle East has had a minor impact on markets – so far

Recent events in the Middle East have already had a ghastly human toll and there could be much more to come. Beside such considerations, economic issues are decidedly second order.
Nevertheless, there are economic aspects to this crisis and they need to be analysed.
Naturally, how serious the economic consequences prove to be will depend greatly on what happens from here so our judgments are hedged about with uncertainty.
The most important economic variable affected by the Middle East conflict is the price of oil.
Twice in the 1970s, huge increases in the oil price caused a major spike in inflation and simultaneously sent the developed world into a recession. Both of those spikes were associated with trouble in the Middle East so, when a crisis brews up there, it is natural for people to recall what happened then and to run for cover.
More recently, following the outbreak of the Russia-Ukraine war there was a (less severe) spike in oil prices, a surge in inflation, and an accompanying hit to aggregate demand in the developed world.
In fact, the scale of the increases in oil prices in the 1970s is in a different league from both the increase in oil prices caused by the Russia-Ukraine war and recent price flurries. (Mind you, in 2022 the rise in the price of natural gas in Europe was highly significant.) In 1973/4, the oil price rose by over 300pc and in 1979/80 by nearly 200pc. What’s more, in those days the international monetary regime was a tinderbox. The sharp rise in oil prices was the match.
Moreover, GDP was much more oil intensive then than it is now.
As a rule of thumb, a 5pc increase in oil prices now adds about 0.1pc to the inflation rate in advanced economies. At the time of writing, Brent crude is about $78 per barrel, which is about 8pc higher than it was a week ago, but marginally lower than it was at the end of August. Indeed, the current price is close to the lower end of its post 2022 range.
Accordingly, there isn’t a great deal to write home about.
With regard to where the price goes from here, the key consideration is the willingness and ability of Opec, and particularly Saudi Arabia and the UAE, to increase oil production in the event of any damage to Iranian oil infrastructure. Iran accounts for about 4pc of global oil output. The combined spare oil production capacity of Saudi Arabia and the UAE is well in excess of that.
But whether they choose to increase supply depends upon the outcome of a debate about these countries’ optimum price strategy. You might think that Saudi Arabia needs a higher oil price in order to boost its tax receipts and thereby improve its fiscal position. Indeed it needs oil prices to be more than $90 per barrel to balance its budget.
But it has huge reserves of oil, and it faces a strategic danger that it hangs on to most of its reserves for so long that the Oil Age is over, with its oil in the ground now worthless. As the late Saudi oil minister Sheikh Yamani used to say, the Stone Age did not come to an end because of a shortage of stones. 
Such thinking argues in favour of pumping out oil now and keeping prices relatively low.
Thankfully for the rest of us, it seems that in current circumstances Saudi Arabia is leaning towards offsetting any reduction in oil supply caused by a fall in Iranian production by raising its own output.
Mind you, that is not necessarily the end of the matter. In the event of a full-blown conflict, Iran might seek to block the Strait of Hormuz, through which the bulk of Middle Eastern oil production must pass. Admittedly, it would be possible to divert some oil supplies by pipeline to Red Sea ports. And if the closure of the strait was causing serious problems, the US and its allies would surely intervene to keep it open.
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So far at least, the impact of the gathering crisis in the Middle East on financial markets has been pretty minor. Both equities and bonds have hardly turned a hair. The one notable move has been a strengthening of the US dollar as, in time-honoured fashion, international investors have sought a safe haven.
We have been caught up in this development as the pound has fallen from over 1.34 against the dollar to just under 1.31. In fact, this isn’t particularly significant either. Much of this move is down to comments from the Governor of the Bank of England who has indicated that the Bank may need to accelerate the pace of interest rate reductions. You can see this impact from the fact that the pound has dropped a bit, not only against the dollar, but also against the euro.
When the pound falls, this normally causes an upward spike in consumer prices and it can thereby result in a temporary increase in the inflation rate. This time, however, the price structure across the economy had surely not yet fully adjusted to the earlier strengthening of the pound against all major currencies. The recent slight weakening should be seen simply as a partial unwinding of that earlier strength and accordingly should have next to no impact on inflation.
Therefore, so far at least, it looks as though the economic impact of the Middle Eastern crisis on the world economy is going to be fairly minor. Moreover, in the context of weakening demand and increased supply in the oil market, over the next year the likelihood is that oil prices will soften.
The major geopolitical danger in the current crisis surely arises from the risk of simultaneous events in the two other major flashpoint areas – Russia-Ukraine and China-Taiwan. If the worst were to transpire there, then all bets would be off.
Roger Bootle is senior independent adviser to Capital Economics. [email protected]