How will the “weaponization” of oil used by Iran stop affecting the global economy?

The global economy is now walking a tightrope, poised to sink into a nightmarish stagflationary universe. The “weapon” of oil, which historically has brought down empires, is being put to use again after the outbreak of war in the Strait of Hormuz. There has been no substantive agreement to reopen the Strait of Hormuz, as the United States and Iran remain far apart on their demands, with the Iranians holding more bargaining power than US President Donald Trump ahead of the US midterm elections in November. In the absence of a comprehensive deal, a resumption of hostilities was highly likely, as reflected in the growing risk of a return to all-out war. Nevertheless, stock markets are rallying on hopes that a ceasefire would lead to a full agreement. The overall economic impact, in terms of growth and inflation, has also been relatively modest. While this is the largest disruption to global oil supplies ever recorded, the oil shocks of the 1970s had a greater impact. Iran’s strategy continues to rely on the use of oil as a weapon, a practice with a long history.

• Some historians argue that Germany lost World War I in part because an Allied naval blockade deprived it of oil.
• Similarly, Imperial Japan made the fateful decision to attack the American fleet at Pearl Harbor because the administration of US President Franklin Roosevelt had imposed an oil embargo on it due to its invasion of China.
• Stalin would later argue that the Nazis lost World War II because the Soviets prevented the Axis powers from seizing the oil fields of the Caucasus.
• After the war, the Suez Crisis of 1956 disrupted oil shipments from the Middle East to Europe, when France, the United Kingdom, and Israel launched an operation to seize the Suez Canal after it was nationalized by Egypt.
• (They were eventually forced to withdraw under pressure from the United States, which was focused on preventing a conflict that could involve the Soviets.)
• A decade later, the Six-Day War between Israel and several Arab states was triggered by Egypt’s attempt to block Iranian oil shipments to Israel through the Straits of Tiran.

Severe Impact

The geopolitical turmoil of the 1970s led to a lost decade of stagflation (several recessions and high inflation), weak stock markets, and double-digit bond yields. The impact was so severe that the 1970s remained deeply etched in our collective memory. However, like this year’s war, subsequent politically motivated oil crises,

• following Iraq’s invasion of Kuwait in 1990,
• the oil shock of 2000–01,
• the US invasion of Iraq in 2003, and
• last year’s 12-day war against Iran,

had much milder economic and financial impacts. The reasons are: After the 1970s, OPEC producers realized that using oil as a weapon could be counterproductive. An oil shock large enough to cause global stagflation would eventually lead to a collapse in oil demand and prices, as occurred in 1981–82.

As a policy of counterbalancing the “weaponization” of oil

1. Saudi Arabia and the Gulf states increase supply when geopolitical turmoil causes sharp increases in oil prices. 2. Since the 1970s, gains in energy efficiency have tended to reduce the share of imported oil used in production and consumption. 3. OPEC’s power has waned as its members have put their own interests above the need to act in concert (with the United Arab Emirates the latest defector), while new sources of supply have entered the market, notably in the United States following the shale revolution. 4. Following the oil shocks of the 1970s, major oil consumers, including the United States, Europe, China and Japan, have also built up strategic oil reserves that can be released when prices spike (providing a significant source of resilience this year). 5. At the same time, alternatives to oil—natural gas, renewables and new, safer modular nuclear reactors (with fusion power likely to become available in the next decade)—have gained momentum and market share.

Future adaptation

Looking ahead, an increasing share of energy demand (via electric vehicles and batteries) will be met by electricity that can be generated without the use of oil. At the same time, the usual macroeconomic policy response (both fiscal and monetary) to oil shocks has improved, helping to prevent a release of inflation expectations, as occurred in the 1970s. And partly as a result of these factors, oil shocks have become less persistent and shorter-lived than those of the 1970s, which lasted about a decade. The oil shock of 1990-91 lasted nine months, the one of 2000-01 was even shorter, and the shock that followed last year’s 12-day war lasted only a few weeks. Most importantly, unlike previous periods in which macroeconomic and financial trends were dominated by an oil shock that developed into a negative aggregate supply shock, the current situation is characterized by a structural positive aggregate supply shock in the form of the investment boom in artificial intelligence (AI). The tailwinds from the technology sector are boosting growth and curbing inflation in many countries and regions, which explains why US stocks reached new highs even as oil prices topped $100 a barrel this spring. Although there has been a correction since then following the resurgence of hostilities, it has remained limited. Of course, a prolonged conflict would increase the risk of a truly stagflationary development. This is not the baseline scenario, however, recent developments suggest that tail risks are greater than financial markets currently value.