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The Effect Of Middle East Collapse

Martin Hutchinson

The series of revolutionary movements around the Middle East raises the possibility of a general collapse of current Middle East regimes and their replacement by populist governments. Judging by current rhetoric, those governments would be anti-western and anti-capitalist, making their economies inefficient hotbeds of waste and unrest. Given that the West gets a high percentage of its oil from the region, it has always been maintained that the effect of such a turnover in the Middle East would be catastrophic. But would it?

To get an answer, we must first define how great an effect a Middle Eastern revolution would have on the energy markets, the only sector in which disruption in the region can seriously damage the global economy. Currently, since the demonstrations are confined to countries in the Middle East and North Africa, we can reasonably assume that regime change would only affect Middle East/North Africa members of OPEC (for example, not Nigeria, which is more or less a democracy.) We should also assume that it will not affect Iran (where regime change might, after a short-term disruption, increase oil production.) Rather more doubtfully, we can assume that Iraq’s democratic government (and 50,000 U.S. troops) will protect it from similar disruption. The oil producing countries disrupted would thus be limited to Saudi Arabia (much the largest, at 8.13 million barrels/day produced in 2010) the UAE, Kuwait, Qatar, Libya and Algeria, plus the Neutral Zone between Saudi Arabia and Kuwait.

All told, those countries had oil production of 16.61 million barrels/day in 2010, 56% of total OPEC oil production. Add in natural gas liquids, and together they represented 22.7% of total world hydrocarbons production, according to the International Energy Agency.

In the short term, battles in the streets in a country could cut off its oil production altogether. In the longer term, revolutions in these countries are likely to be fairly short in duration, and confined mostly to the cities, although if Libya’s Muammar Gaddafi starts a fashion of blowing up oil pipelines we may have to recalibrate this calculation. The new governments are almost certain to be anti-Western, anti-capitalist and economically incompetent – like the post-1979 clerical regime in Iran, for example.

However since these countries are overwhelmingly dependent on oil revenues they will be determined to sell oil, possibly to China, just as does the anti-capitalist, anti-Western and economically incompetent Hugo Chavez regime in Venezuela, or the anti-Western, anti-capitalist but by now not completely economically inept regime in Iran. Thus it is very unlikely that 100% of oil production will be lost. The amount lost, once the new regimes have settled in, will doubtless vary – one is probably more pessimistic about Saudi Arabia, the UAE and Kuwait, where efficiency has been relatively high, than about Libya or Algeria, where the governments are already anti-capitalist and highly corrupt.

As a benchmark, Iranian production fell in 1979-80 from about 6 million barrels/day under the Shah’s fairly effective and pro-market regime to about 3 million barrels/day under the regime that followed (it has since inched up over the years, in spite of depleting reserves, to about 3.7 million barrels/day today.) We can thus estimate that oil production lost might be 50% of its current total, or 9.85 million barrels/day (including liquids) or 11.4% of the 2010 world production total of 87.3 million barrels/day. The loss might well be higher in the short term, but on the other hand non-OPEC oil sources have a certain amount of reserve production capacity, and global inventories could be drawn down.

A loss of 11.4% of global oil production doesn’t sound all that serious. The world economy would certainly be much worse off if China fell into disarray, for example, in which case not only would output from the immense array of Chinese factories be lost, but over 90% of the world’s supply of rare earths would be imperiled, producing a crucial bottleneck in the world’s advanced electronics supply. Nevertheless, even if the newly militant Middle Eastern regimes refused to deal with the United States or its close allies, there would be no danger of an oil cutoff, since the new regimes’ supplies to China and other non-Western countries would simply replace non-OPEC supply in the world distribution pattern. Furthermore, the existence of huge oil shale and tar sands deposits, together with the potential to expand non-OPEC sources of supply suggests that the disruption in supply would not persist beyond 4-5 years, after which unconventional and other new supply sources would kick in. However, if the production loss appears modest, examination of demand elasticity suggests that its effect on price would be severe.

To calculate the short-term (up to 24 months, before long-term demand adjustments can be made or significant new supplies can appear) demand elasticity of oil, we now have an excellent control experiment, in the events of 2007-08. Between the summer of 2007 (April – September) and the summer of 2008 the U.S. economy expanded marginally, by 0.45% in real terms. The average global oil price increased by 70% between those two half-years, from $68.43 to $116.34. On the other hand, U.S. oil demand declined by 3.54%, from 20.902 million barrels/day to 20.163 million. If we assume that, given flat prices, demand would have increased by the same 0.45% as the overall economy, then the 70% price increase caused a demand drop of 3.99%, say 4% — a demand elasticity of 4/70.

Given that elasticity, to make demand drop sufficiently to absorb an 11.4% fall in supply would require a price increase of almost exactly 200%. In other words, oil prices would have to treble from the current $100 per barrel to $300 per barrel. The U.S. gasoline price would increase from its current $3.19 per gallon average to $9.57 per gallon.

The U.S. market is of course not typical. For one thing, its taxes are much lower than in Europe. Since most gasoline taxes are roughly flat, British prices would increase from their current 1.29 pounds per liter not to 3.87 pounds but only to about 2.40 pounds. The decrease in demand would be correspondingly less. However in poor countries, or those where fuel costs are currently subsidized such as China and India, the decrease in demand might well be greater. In those countries it would become impossibly expensive to maintain the current level of subsidy, so transportation patterns would shift back to those only recently foregone (bicycles replacing cars, for example). Overall therefore, a trebling of oil prices appears a reasonable expectation from a full political disruption of the Middle East.

The short-term social effect of $300 oil would be less than many people believe – certainly than many environmentalists, advocating “cap and trade” energy policies believe. The additional cost for the average driver, even one who currently uses 500 gallons of gasoline a year, driving 12,000-15,000 miles, would be $2,700 – he saves a little by reducing his usage by 11.4%. That’s nowhere near enough to afford the payments on a $41,000 Chevy Volt. Thus even a major collapse in the Middle East would leave our automobile culture very much as it is today. There would be some switch back to public transport, some abandonment of particularly remote suburban tracts. However the new and stricter EPA mileage standards for automobiles, due to come into effect in 2016, would still be a huge economic drag, since they would still pull the system a substantial distance from the position that a free market would dictate, even at $300 oil.

Economically however it’s a different story. Net U.S. imports of petroleum were $265 billion in 2010, about 1.8% of GDP, with an average oil price of $79 per barrel. With oil at $300 per barrel, even with 20% less imported (the U.S. produces about half its oil consumption) that figure would become around $800 billion, pushing the U.S. balance of payments deficit above $1 trillion and draining an additional 4% of GDP from the U.S. economy. It’s likely that this would bring about a second recession, somewhat deeper than that of 2008-09, undoubtedly accompanied by substantial inflation, almost certainly in double digits (whatever “core” inflation did the prices people actually paid would rise by more than 10%).

At this point, the crucial need would be to restrain the politicians and the Fed. A response like that of 2008-09, in which interest rates were pushed back to zero (minus 10% in real terms) while $1 trillion of further “stimulus” was injected into the economy, pushing the Federal budget deficit to around $3 trillion (when you include the recession’s direct fiscal effect) would be quite literally disastrous. The $3 trillion deficit, combined with a $1 trillion balance of payments deficit, would cause the dollar to collapse and make it impossible to finance the Federal budget deficit. The hugely negative real interest rates, with inflation already in double digits, would cause inflation to become hyperinflation. The United States would share the fate of the 1923 Weimar Republic, with trillion percent inflation and economic collapse. Thus if President Obama and Fed Chairman Bernanke are still in power when the Middle East collapses, we are in for deep, indeed probably terminal trouble.

With good policy, however, the fiscal and monetary adjustment would become little more ferocious than the similar albeit lesser adjustments to oil price rises in 1973 and 1979-80. Like the Fed of Paul Volcker, a competent Fed would push interest rates up moderately above the inflation rate, thus bringing inflation back under control and, by rewarding savers properly, rebuilding the U.S. capital base that has been so sadly depleted. By making capital investment expensive, this would also encourage employers to hire labor, bringing back the exuberant job creation of Ronald Reagan’s “Morning in America.” A competent Congress and executive would also slash government spending, creating room in the capital markets for the private sector to obtain finance and reducing the strain on the balance of payments from excessive government consumption. The recession might be momentarily deeper than that of 2009, with the worst quarter seeing perhaps an 8% drop in GDP, but the recovery would be swift and energetic, pulling people back into work and rebuilding a healthy economy.

The overthrow of current Middle Eastern governments and their replacement by radical Islamists, while unpleasant, need not bring the collapse of Western economies and civilization. Only our own governments and monetary authorities can produce that!


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