By John Kemp
LONDON Feb 22 Political leaders in the United States and Europe could soon face an uncomfortable choice between raising the pressure on Iran further or taking steps to safeguard their economies from the damage wrought by rising oil prices.
Confrontation with Iran and a series of supply disruptions in South Sudan, Syria and Yemen have pushed prices back to levels that derailed the recovery in the United States and Europe last year, and could do again in the first half of 2012.
If prices continue rising, releasing oil from government-controlled stockpiles will look attractive to policymakers keen to maintain the embargo but anxious to avoid a stalling economy in a U.S. election year.
Experience suggests the full extent of the damage will not be apparent until the second or third quarter, because oil prices filter through to measurable changes in consumer spending and business investment with a lag of several months.
The best way to understand how oil prices are likely to affect the economy is to examine how the recovery was influenced by the last big rise and fall in prices between August 2010 and April 2011 ().
Between August 2010 and January 2011, front-month Brent prices rose $20 per barrel (25 percent) following Fed Chairman Ben Bernanke's Jackson Hole speech foreshadowing a second round of quantitative easing, and then another $26 (27 percent) between February and April following the outbreak of the Libyan civil war and the earthquake at Fukushima.
Throughout the period the economy appeared impervious. Many oil analysts dismissed reports of demand destruction as "premature" and predicted prices would need to rise much further to bring demand back into line with restricted supply .
Equity prices rose strongly. The Standard and Poor's 500 index rallied over 20 percent between August 2010 and April 2011.
The U.S. economy continued to report big gains in manufacturing output and employment. The Institute of Supply Management's (ISM) composite manufacturing index averaged 58.5, well above the 50-point threshold dividing expanding activity from a contraction. Private sector employers averaged payroll gains of 185,000 positions per month.
Then it all went wrong. May proved to be the cruellest month. Oil prices plunged, but too late to save the recovery .
Private sector job gains slumped from 264,000 in April to 108,000 in May and 102,000 in June. The ISM composite collapsed more than 5 points, and another 4 points by July.
The economy stalled, prompting the Federal Reserve to promise further stimulus at its August meeting in the form of a soft commitment not to raise interest rates until at least the middle of 2013.
Many macroeconomists and oil analysts dismiss comparisons with the rise in oil prices in 2011, arguing the recovery is now much more well-entrenched. In particular, they point to growth in manufacturing and employment as a sign the economy is on the mend and should be able to weather price increases.
But evidence for this view is scant. Private job gains in December (220,000) and January (257,000) are almost exactly in line with job creation in February (257,000) and March (261,000) last year. The ISM's composite index (54.1) is actually below year-ago levels (59.9).
The current level of the S&P 500 (1362) is not much different . The Fed is providing strong support for the recovery with its prediction interest rates will need to remain low until at least late 2014, but last year it was also providing strong support by completing its $600 billion bond-buying programme.
Historical parallels are never exact. But there are enough similarities that it would be foolish to dismiss the threat of a similar slowdown in the economy in the months ahead, most likely to be felt between March and June.
There are already signs the recovery is faltering: an unexpected dip in U.S. consumer confidence this month; business surveys pointing to a continued contraction in manufacturing activity across the euro zone; and the fourth consecutive monthly contraction in China's manufacturing sector in the face of slowing export orders .
Political leaders across North America and Europe are caught in a dilemma. On the one hand, most are convinced of the need to maintain sanctions on Iran's exports and continue pressuring the government in Tehran to curtail its uranium enrichment programme. Facing a tough re-election fight later this year, U.S. President Barack Obama cannot afford to show any sign of weakness in foreign policy, especially towards Iran.
On the other hand, the president's re-election hopes could be sunk if rising oil prices push the economy into recession. European governments could also be vulnerable if voters blame rising oil prices on sanctions and conclude the embargo was an own goal.
Political pressure to cap or reverse the rise in oil prices is already high. It will become intense if prices break through last year's highs around $125 (Brent) and $110 (WTI) and the rise is blamed on the sanctions process.
CURBING PRICE RISES
Assuming that tensions with Iran cannot be defused, and policymakers opt to maintain sanctions, there are a number of options for trying to blunt the economic impact.
The simplest would be to encourage more Iranian exports to China, India and other markets across Asia. The original sanctions "game plan" called for rising exports of (discounted) Iranian crude to China and other developing markets to offset the loss of market access in Europe, Japan and Korea and keep global oil supplies steady.
The plan has gone wrong because Iran has so far refused to offer large enough discounts and many Asian buyers are wary of taking Iranian oil and relying on uncertain U.S. forbearance from enforcing penalties. U.S. officials could, however, re-emphasise that a certain level of "permitted non-compliance" is assumed and even encouraged.
Such messaging is difficult to get right. But arguably U.S. and European officials could do more to reassure Asian crude buyers that they will not be punished for buying Iranian crude.
The second option is to try to resolve some of the other disruptions currently affecting oil supplies. Western governments may not be able to do much about the loss of crude from Syria, but officials could step up pressure on Sudan and South Sudan to settle their dispute over transit fees.
IEA STOCK RELEASE?
The third option is to order another release from government stockpiles. So far, officials have implied stocks would only be released in the event of a disruption to oil flows through the Strait of Hormuz. In reality, the conditions for release are likely to be interpreted more flexibly.
A pre-emptive release of supplies to forestall a dangerous rise in prices is probable if officials assess there is a threat of Brent prices breaking through the $125-130 level.
Purists will complain the International Energy Agency (IEA) should not release stocks unless there is a loss of Iranian and/or Saudi exports, but the bar to releasing stocks is much lower.
Declining commercial inventories and the loss of physical supplies from South Sudan, Yemen, Syria and as a result of complications around Iran's exports, coupled with the need to avert the economic fallout from a further rise in prices, would provide the immediate justification.
In its statement justifying last year's release, the IEA cited "the ongoing disruption of oil supplies from Libya. This supply disruption has been underway for some time and its effect has become more pronounced as it has continued ... Greater tightness in the oil market threatens to undermine the fragile global economic recovery."
Rightly or wrongly, the same logic could be applied to the loss of exports from Iran and South Sudan.
Stock releases are above all a political decision. If prices continue rising, the pressure to counter them by releasing stocks may become irresistible.