An Off Ramp on the Road to War

When Iranian-backed mobs stormed the American embassy in Iraq, and Trump responded by ordering that Major General Qassem Soleimani be permanently removed from his day- and night-job as chief organizer of terrorism in the region, many forecasters scrapped their outlooks for 2020. Then both the Iranian Ayatollah and the American President confined themselves to restrained responses and declared themselves satisfied, at least for now. Both agreed, although for different reasons, that the ultimate objective of their separate polices is the removal of all American troops from Iraq and, indeed, the Middle East. The Iranians want to expand their footprint, the President to redeem a campaign pledge.

Investors sighed with relief and retrieved their economic forecasts from the trash cans into which they had been tossed. The consensus outlook remains as before the recent escalation in tensions.
Growth likely to continue at a satisfactory although possibly slower pace,

  • Corporate earnings likely to rise somewhere between 7% and 9% after a flat year,
  • inflation nil even though wages are rising, especially at the low end,
  • consumers happily spending their rising incomes,
  • the housing sector awakening from a long slumber,
  • share prices resuming their skyward march.

Economists would not be paid-up practitioners of the dismal science if they did not warn these optimists that the usual recession-fighting policy tools are not available. “The old methods won’t do”, former fed chairman Ben Bernanke told a meeting of economists last week. Monetary policy is already so loose, federal deficits so high as to be unsustainable, that tax cuts would be politically difficult and probably economically disastrous. And interest rates are already so low that the Fed can’t lower them further to stimulate the economy should a recession hit. Negative rates, yesterday’s fad, might help a bit, but not enough to offset the long-run risks they create.

Then there is that not-so small problem of uncertainty. Certainty is what investors and corporate executives say they need if they are to do their share to keep the economy growing. Alas, certainty is not in Donald trump’s DNA. He can give Wall Streeters and CEOs lower taxes; he can give them pressure on the Fed to lower interest rates; he can peel back regulations; he can run a loose, deficit-ridden fiscal policy, but certainty – no dice. He is already threatening new trade wars with France and the EU.

With both Trump and the Ayatollahs having found an off-ramp on the road to war, concern now focuses on whether Iran will attempt to interrupt the flow of world oil. That would create more of a problem for the Asian and European countries dependent on Middle Eastern oil than for the US. Fortunately for America, this is not the 1970s, when the Arabs cut oil supplies, creating long queues at gas stations, and significant economic disruption. America at that time relied heavily on imported crude from the Middle East; today it is a net exporter.

If Iran successfully disrupts, or seems likely to disrupt the flow of oil to world markets by again torching oil facilities in Saudi Arabia, or by making passage through the Strait of Hormuz chancier, any increases in the price of crude and gasoline will, of course, reduce the cash consumers have to spend on other things. But the incomes of American oil workers and investors will increase. Most studies conclude that any fall in consumer spending on stuff other than oil products will be offset by increased investment and higher incomes in the US oil patch.

Besides, the ability of Iran to cause a spike in the price of crude is limited. Prices in the US rose after the killing of Soleimani, only to return to earlier levels in a few days. When the Houthis hit the Saudi facilities on September 14 last year, the benchmark Brent price jumped by almost 15% (from about $60 per barrel to $69), only to drop to below the pre-attack price in a few weeks. Even if a sustained rise in oil prices were to occur, slowing growth in America’s export markets, the US economy is unlikely to be significantly affected. Exports account for only 12% of U.S. GDP, compared, for example, with the euro area, where exports account for 46% of GDP.

In a crisis, much would depend on America’s frackers. They account for about 60% of the 12.3 million barrels of oil per day produced in America. That far exceeds the output of number two, Saudi Arabia, and number three, Russia. The US Energy Administration expects output to rise to 13.2mbd this year, with most of that increase coming from the Permian Basin and other shale oil deposits. So there is no fear of gas-station queues, although shortages of some grades of crude oil are a possibility.

But because output from the frackers’ wells can decline by 70% in the first year of production, compared with 5% for conventional wells, new wells must be drilled to keep production steady and rising. That takes capital, and more capital. “The industry has destroyed so much capital for so long,” Neuberger Berman’s Todd Heltman tells Bloomberg, that investors have fled. Many companies are deeply in debt, smaller ones have gone bankrupt. No surprise that 25% fewer oil rigs are now searching for and developing oil reserves than at this time last year. Still, the best bet is that increased efficiency will enable American producers in the Permian Basin and other areas in which frackers operate to offset any Iran-created supply interruptions. Which will give Trump another opportunity to claim that his deregulation policies are the reason America is an oil-rich county.

Unfortunately for him, Friday’s job report fell short of expectations – 145,000 new jobs in December compared with 256,000 in November, further weakness in manufacturing, a sector containing many core Trump voters, slower wage increases – denying him the usual chortle and an opportunity to change the subject from impeachment and a nervous-making foreign policy to the economy, stupid.