Surviving Oil-Price Chaos

Middle Eastern oil production risks falling into radical control...

TODAY'S UNREST and violence in the Middle East oil patch is roiling the global oil markets on an almost daily basis, says historian and finance veteran Martin Hutchinson at Money Morning.

The events in Egypt, Libya, Saudi Arabia, Oman and other countries are also forcing us to ask that long-dreaded question: What happens if countries throughout the Middle East region fall to radical governments?

In an absolute worst-case scenario – if the entire Middle East falls under extremist control – we could be looking at $300-a-barrel oil and US pump prices of $9.57 a gallon. Definitely a stunner.

But here's the surprise: Even such the worst-case outcome would not result in the end of Western civilization as we know it. In fact, you can hedge yourself against such a meltdown.

First, the risks. Between them, the Middle Eastern and North African (MENA) countries produced 22.7 million barrels per day in 2010, rather more than US consumption. However, two of those countries can be left out of the equation. Iran already is run by radicals – any change there would be an upgrade. And Iraq is a democracy that's host to 50,000 US troops; one must hope that a regional collapse would pass it by.

Realistically speaking, even if run by radicals, Middle Eastern countries will not stop exporting oil; they need the money. And it won't even matter if these countries refuse to export to the West: If their oil goes to China, India or elsewhere, it will simply be a substitute for – and therefore free up – oil that had been coming from other regions.

Now I will concede that a wholesale change to economically inept regimes in the Middle East will lead to reduced output. For instance, when the Shah Mohammad Reza Pahlavi was ousted in the Iranian Revolution of 1979, output fell from 6 million barrels a day to 3 million – a 50% decline.

A decline of a similar magnitude seems a reasonable assumption for Middle East countries that succumb to radicalism. If all of them except Iran and Iraq went radical, that would reduce global energy output by 9.9 million barrels per day – or 11.4% of last year's total world output.

It used to be very difficult to figure out how much price effect a supply shortfall might have, but fortunately we now have a "control experiment" to use as a model. I'm talking, of course, about the record-oil-price spike of 2007-08.

Between the summer of 2007 and its successor in 2008, oil prices rose by 70% while US consumption fell by 4% (when the year's modest economic growth is corrected for).

That means the "price elasticity of demand" – an economic term that measures the responsiveness of buyers to a change in price – is about 4/70. Plug that figure back into the supply shortage of 11.4% and you get a price increase of about 200%. In other words, were we to have a "worst-case scenario" revolution in the Middle East, we would be looking at the current price of oil (about $100 per barrel) increasing by 200% to about $300 a barrel.
 
You can quibble with the exact number, because Europe has higher gas taxes than the United States, so would see less of a drop in demand than we would. Emerging-market economies, on the other hand, are much poorer, and might well see an even-bigger drop-off in demand, perhaps even returning to bicycle transportation.

Even so, our $300-a-barrel estimate feels like a good round number that's backed by logic and a certain economic soundness.

Under such a scenario, we'd be looking at US gas prices of about $9.57 a gallon – up from the current $3.19. The cost to the typical US motorist – who uses about 500 gallons of gas – would be an additional $2,700 (assuming that his usage declined by 11.4%).

That's not enough to afford the payments on a $41,000 Chevy Volt, suggesting that government-backed schemes to shunt the citizenry out of their gas-guzzlers still remain uneconomic – even with crude oil at $300 a barrel.

The more-damaging economic impact would be on the US balance of payments. The $265 billion that it cost to import oil in 2010 would balloon to about $800 billion. And that's including the decline in oil-related consumption that would result from the big surge in oil and gasoline prices.

Were this scenario to become real, we'd watch as the US balance-of-payments deficit soared to more than $1 trillion. We might even see a collapse of the US Dollar – at the very least, an implosion of the greenback would be a very real possibility.

Pulling 4% of gross domestic product (GDP) out of the US economy would absolutely tip us into a recession. And this second downturn would be somewhat deeper than its 2008-09 predecessor.

Inflation would also be a problem, probably rising into double digits as it did in the 1970s – essentially "stagflation," given the already-high unemployment rate the nation currently faces.

At this point, it would matter a lot what government and the US Federal Reserve opted to do. If the administration then in office followed the fiscal "stimulus" and ultra-loose money policies of 2008-10, the result would be economic collapse. The budget deficit would soar toward $3 trillion, and the shortfall would be impossible to finance. Nobody would want to buy that amount of US Treasuries from a country with such a massive balance-of-payments deficit.

Meanwhile, with short-term interest rates 10% below the inflation rate, inflation itself would spiral into hyperinflation.

Such a collapse would be avoidable with different policies. If interest rates were raised a few points above inflation, that would reward savers, and provide a brake on inflation. It would also produce a Reagan-era rate of job creation, as high interest rates would make it cheaper for employers to hire labor than to invest in expensive equipment.

Finally, reducing public spending and thereby reducing the deficit would also free up the capital markets and banking system for small business, normally the chief creator of jobs. Thus, in this scenario, the nasty recession would be brief, and would quickly give way to healthy, vigorous recovery with inflation declining.

A broad revolution in the Middle East does not necessarily translate into a total economic collapse here. But how our country fares – and whether we avoid such a meltdown – completely depends on how our elected leaders and central bankers react.

No matter what happens, you don't have to suffer. In fact, as an investor, hedging against the possibility of a Middle East revolution is surprisingly easy. The right oil stocks in Canadian tar sands are somewhat expensive with oil at $100 a barrel. But at $300, they're a steal!

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