Saudi Oil Attacks: An Economic Tipping Point?

Over the weekend the world was stunned by the alarming news that two drone strikes had hit two of the largest oil facilities in Saudi Arabia. The result being an estimated loss of 5.7 million barrels of daily oil production in the short term.

With the global economy already teetering on the verge of an economic slow down the possible economic question now is whether this is the straw that breaks the camel's back. Is it?

Quite possibly, as the numbers historically might suggest.

The loss in daily oil production is a sizable amount and according to some estimates, possibly the largest single day drop in production that would make it a legitimate oil shock, on par with the oil shocks of the late 1970s and early 1980s which plunged the US into recessions on both occasions.

Things were different then compared to now, as the US has since then weaned itself of being susceptible to global oil shocks by generating reserves that it can tap into should a full blown oil crisis emerge, but will this be enough to both supplement, for the foreseeable short to long term, the reduced global production, calm markets which are already in a frenzy, and address the ongoing concern in the Middle East over security - concerns that could lead to even further oil production cuts in the region should the attacks or genuine fears of attacks persist?

As of late Monday evening following the weekend attack, oil prices have shot up 16% in spite of attempts by the Trump administration to try to allay concerns by pointing to our ability to tap into those oil reserves - reserves that currently in the range of about 645 million barrels according to the US Department of Energy. How all of this plays out over the coming days are crucial, here is a scenario I think very likely...

This is the tipping point for where the US economy officially starts to weaken.

For one, we are still mired in a trade war with China which has already begun to take its toll in the background. While the full impacts of this trade war have so far been tempered by policies intended to cushion their impacts: the lingering effects from tax reform policies for households, and businesses, the agricultural and farm subsidies being provided to farmers, and the Fed's accommodative position in keeping interest rates low; the most recent trade report (for July) tells us what economists have long emphasized: the trade deficit with China actually increased even further. Why? because import restrictions are tantamount to export restrictions. This is a direct result of a reduction in Chinese holdings of US dollars from reduced imports, but this is all the more enhanced by the retaliatory trade actions taken by China.

The effect of the trade war has been to artificially raise prices of a wide variety of affected products along the entire supply chain and the higher oil prices will only add to these costs for businesses and the inflation that has somehow been absent will likely resurface from the higher energy costs that result for businesses. This of course will create a dilemma for the Federal Reserve, as all oil shocks typically do. A dovish stance by the Fed will perhaps slow the impending recession but will likely see inflation rise more quickly, perhaps to levels we have not seen in recent years. A more hawkish position will speed the slowdown of the economy.

Financial markets have also signaled a possible economic slowdown with the yield curve having inverted late in August, and while the 10 year rate has climbed back above the two year rate on Treasury notes, the curve is still fairly flat indicating that the worst is not yet past in terms of market concerns about the direction of the economy.

From across the Atlantic the slowing down of major EU economies coupled with the impending Brexit storm will be further impetus to hasten a slowdown here in the US. As Europe reels from the oil shock that steepens its slide into an inevitable recession (they already have the telltale signs of a recession in many of their macro variables), their reduction in incomes and the necessary expansionary policies by the European Central Bank and the Bank of England, will spill over into the US creating further reductions in our exports as the euro and pound weaken further against the US dollar.

There is also the reality of the global arrangement we live in. It is easy to bash China to obtain political brownie points but slow economic growth in China affects businesses who have invested much in outsourcing production over there. That slow growth will lead to lower incomes and profits for US businesses over there and in other parts of Asia that are also experiencing slower growth rates. Such reduction in foreign earnings will lead to reduction spending in the US and further slow the economy down. All of that will further be amplified by the increase in global energy prices that will result from this oil crisis.

Any possible policy intervention?

A possible three fold policy may stave this off: First, a willingness by the administration to concede somewhat on the trade war and roll back the tariffs. This will be really difficult for President Trump to do, but he is artful enough to couch this in terms that suggests he is doing China a favor or/ and doing this as a gesture of goodwill to help stabilize both its and the global economy in general.

A second policy would be to expedite tapping into our oil reserves and for the US to act as a global supplier of last resort, while putting every effort into helping both Saudi Arabia and other oil producers ramp up oil production through provision of additional security measures and and foreign and logistics aid.

The third policy would be some form of continued supply side measures including further business and payroll tax cuts, as have been tabled recently by President Trump. While these policies will possibly have long term costs including having the deficit grow at a faster rate, the immediate need to stem an economic recession in the possible form of stagflation may warrant such short term policies.

A perhaps helpful fourth policy would be the Fed continuing to keep interest rates low and maintaining an accommodative stance with reassuring forward guidance. Given the actions taken explicitly by the government above, there would be little concern for inflation. Consumer fears would be allayed, so business concerns and investment plans would need the assurance of low interest rates to continue business as usual, especially while they react to the initial shock of higher other business costs.

A mild economic recession is a possible outcome within the coming year, given how this plays out and if these actions are taken more or less, but an even more severe recession is possible in the absence of such intervention.