Suhaib Kebhaj- Washington D.C.
1. Oil prices response to supply shock, Iran this time is different.
Conventional wisdom would assert that a negative shock to supply of crude oil would lead to an increase in oil prices. In reality, the relationship is not this simple. A 2016 study by Economists Peasaran and Mohaddes finds that not all oil supply shocks are equal. Specifically, they find that an oil supply shock to Iranian oil does not lead to long term increase in the price of oil. On the other hand, they find that an oil supply shock to Saudi Arabian oil results in high and persistent increase in the price of oil.
Why is this the case?
According to the study, when supply from Iran is disrupted other countries, such as Indonesia and more specifically Saudi Arabia, act as swing producers increasing their production to compensate for the lost Iranian supply. For example in the period 2011-2014 (the period of sanctions on Iran) Iranian production fell by roughly 800mbpd in the same period Saudi Arabia increased its production by roughly 800mbpd. On the other hand, there are no swing producers to compensate for lost supply in the case of a shock to Saudi Arabian supply.
What does this mean for Oil Prices?
Accepting the findings of Peasaran and Mohaddes we would speculate that in the case that Trump does not extend the Iran nuclear deal, The US would resume sanctions on Iran. This would lead to a negative shock to Iranian oil supply which would result in a short period of increased oil prices followed by a rebalancing due to compensated supply from Saudi Arabia.
But the story does not end here. OPEC (lead by Saudi Arabia) and other big oil producers (namely Russia) have committed to reducing production till the end of 2018, and recently Kuwaiti officials have hinted that the OPEC cuts might be extended further into 2019. This means that in the case of a disturbance to Iranian supply, oil producers agreeing to the cuts might not compensate for the reduced supply after all.
This means, given that Trump does not extend the Iran Nuclear deal which would result in resuming the sanctions on Iran, and depending on Europe’s likelihood to follow in Trump’s lead, we might see oil prices much higher than current levels.
2. Increase in prices, a blessing for some
Is this good or bad news?
The answer to this question depends on the country you reside in. While the jury is still out on whether higher oil prices are a positive or a negative for US and other European advanced economies, we can certainly say that higher oil prices are good for exporters (at least in the short term).
Helping Low-income countries
In a recent interview conducted by NPR with Masood Ahmed, former head of the Middle East Department at the IMF and current head of the Center for Global Development, Masood warned of a debt crisis in Low income countries. In fact low income countries were severely affected by the drop in commodity prices in 2014. Many of these countries rely heavily on commodity exports to fund government expenditures. When commodity prices dropped many low-income countries began to run a fiscal deficit financed by loans from abroad. Over the years these countries have accumulated tremendous amount of debt. Many of these countries are at risk of default.
An increase in the price of oil would result in increased revenue in some low-income countries. This would reduce or close the fiscal deficit in some of these countries reducing the need for additional loans. Further this would reduce the risk of default.