What the Middle Eastern conflict and the oil price mean for economies and currencies
By the OFX team | 14 November 2023 | 5 minute read
Like a stone dropped in a murky barrel of oil, the renewed Middle East conflict has created a ripple effect for Western currencies – and economies – that is only just starting to be felt.
Since tensions escalated in the Gaza Strip on October 7, investors and foreign currency users have taken flight to the perceived safe harbour of the US dollar, the Swiss franc and the age-old ‘currency’ haven of gold.
It is feared the regional confrontation will flare into a major conflagration involving Iran, the US and Saudi Arabia, with even China and Russia potentially becoming involved.
As with past Middle Eastern conflicts, the stakes are raised by that three-letter word: oil.
Those of a certain age will remember the 1970s Arab oil embargoes, which resulted in Western motorists queuing at the pumps and eventual stagflation – rampant inflation and unemployment.
US$150 a barrel?
Since the Hamas attack, the price of Brent crude has notched up from US$84.50 a barrel pre-attack, to as high as US$92 a barrel.
On 7 November, oil fell to a three-month low of US$81.84 as a forecast drop in US petrol consumption, and fears of a decline in China’s economy added to a lower demand outlook. Thus far, the blaring headlines about “soaring” oil prices are well off the mark – but for how long?
In a special report, the World Bank warns the oil price could rocket beyond $US150 a barrel if the hostilities spread beyond Israel and the Palestinian territories.
Ironically, these geographies host barely a drop of oil. But if hydrocarbon-rich Iran, Saudi Arabia or even Iraq are dragged into the conflict, the geopolitical dynamics will change radically – and not for the better.
“An escalation of the conflict is a major risk to commodity markets because the region has a substantial share of the global oil supply,” the World Bank says.
“Historical precedents of military conflicts in the Middle East point to the possibility of significant disruptions in oil markets, with associated surges in prices.
“The ultimate impact of any escalation would likely depend on the magnitude and duration of oil supply disruptions that followed.”
Who produces the most oil?
The World Bank adds the ramifications of any oil price shock would be less severe than during the 1970s Arab oil embargoes, or the 1979 Islamic revolution in Iran.
One reason is that, back then, the US heavily depended on Middle Eastern oil. Now, it’s a net oil importer thanks to abundant shale resources.
According to the World Population Review, the US also was the world’s biggest crude producer in 2022, pumping out an average of 11.6 million barrels per day (mbpd).
This was ahead of the output of Russia (10.5 mbpd, despite being sanctioned), Saudi Arabia (10.2 mbpd), Canada (4.7 mbpd) and Iraq (4.3 mbpd).
How the oil price affects economies
Despite the renewables revolution, oil prices continue to have a significant impact on the global economy. As a result, oil can influence the relative value of currencies in complex and multifaceted ways.
The implications spread well beyond the outlook for the Israeli Shekel or Saudi Arabian Riyal.
If the conflict escalates, risk-averse investors are likely to take their capital elsewhere and this could weaken currencies across the region. More broadly, the oil price is a powerful component of inflation, which remains problematic in most Western economies, notably the US.
As consumers spend more on fuel and less on other things, recession can eventuate.
The tough medicine for inflation is higher interest rates, which tend to support currencies as investors flock to the higher yields on offer.
The trouble is a higher US dollar means the currencies of import-dependent economies – such as Australia – are worth less and this can exacerbate inflation by increasing the price of imported goods.
For major oil importers – including most of Europe – the higher cost of oil can exacerbate trade imbalances and affect currencies (notably the Euro). As a rule, trade deficits tend to weaken a currency’s value while a surplus will strengthen it.
Greenback and oil: an inverse correlation
A key rule of thumb is the historical inverse correlation between the $US and the oil price.
As with most major bulk commodities oil is traded in greenbacks and has been since the 1970s. When the $US is strong, fewer dollars are needed to buy a barrel of oil and the opposite applies when the greenback is weak.
The oil price is heavily influenced by the relative value of the US dollar and the euro, one of the most important currency pairs.
While the US has become a net exporter of hydrocarbons, the European Community depends heavily on exported oil and gas, notably – and problematically – from Russia.
As a result, the USDEUR cross rate has fluctuated because of events such as the Ukraine invasion, which sent oil over US$100 a barrel.
The euro is being devalued by both German economic weakness and inflation pressure, which resulted in the European Central Bank (ECB) hiking rates ten consecutive times.
But the ECB held rates steady at its October 26 meeting, which suggests that – barring an oil price hike – inflation might be easing. The industrial powerhouse of Europe, Germany’s manufacturing sector is suffering from rising costs and a lack of Chinese demand.
On the US dollar side of the ledger, the Federal Reserve’s monetary tightening measures have supported the value of the greenback by increasing interest rates and thus investor returns on government bonds.
Meanwhile, many developing countries depend heavily on imported oil and surging prices can strain their trade balances and currencies.
Protect yourself
As always currency values are determined by a complex interplay of economic data, monetary policy, market sentiment and global events.
But the oil price is certainly playing a leading role and all enterprises affected by currency shifts need to assess their position and protect themselves with hedging or other strategies if needs be.
References
- https://www.worldbank.org/en/news/press-release/2023/10/26/commodity-markets-outlook-october-2023-press-release
- https://www.investopedia.com/articles/forex/092415/oil-currencies-understanding-their-correlation.asp
- https://www.bloomberg.com/news/articles/2023-10-20/ecb-s-peak-rates-to-endure-despite-economic-perils-survey-shows
- https://www.reuters.com/markets/europe/ecbs-kazimir-too-early-call-end-rate-hikes-bet-cuts-2023-10-30
- https://www.businesstoday.in/personal-finance/news/story/is-israel-hamas-conflict-impacting-the-cryptocurrency-market-here-is-what-investors-must-know-402248-2023-10-17
- https://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1689.pdf
- https://oilprice.com/oil-price-charts/