Economic Consequences Of Proposed Iranian Oil Embargo

An effective world-wide refusal to buy Iranian oil would cost Iran dearly. The Iranians would not be the only ones to bear the cost.

"Prices could soar past $100 a barrel, experts say, if the U.N. Security Council authorizes trade sanctions against the Middle Eastern nation, which the West accuses of trying to make nuclear bombs, and Iran curbs oil exports in retaliation. A sharp global economic slowdown could follow."

"Iran Sanctions Could Drive Oil Past $100" by Brad Foss and George Jahn.
Sunday January 22, 6:39 pm ET

The effect on gasoline and heating oil prices is self-evident.

There's another less obvious financial impact to consider.

Many large financial institutions build their asset portfolios with borrowed money. They call that "leverage" in the banking and investment world.

The indebtedness is typically collateralized with a lien on the asset itself. The extent to which a firm leverages its balance sheet depends on the degree of confidence it has in its estimate of future business conditions and the aggressiveness - or foolhardiness as the case may be - of its management.

If a big increase in oil prices reduced the fair market value of equities (or debt securities as well) by impairing profits, such could have an adverse impact on the balance sheets of "leveraged" investors.

"Leverage" is exhilarating on the way up. As the value per share rises, net worth goes up. The more shares, the greater the increase in net worth. The decision to go into debt to acquire those assets appears vindicated.

It's the reverse on the way down. The more heavily "leveraged" the balance sheet, the more quickly the firm heads for bankruptcy.

To people who have no acquaintance with the financial world this sounds more complicated than it actually is.

I'm speaking of simple primary school arithmetic.

If the value of a firm's assets declines, but its indebtedness remains the same, the balance is struck by a reduction in owners' equity.

Once the owners' equity is all used up, the firm's net value goes to zero.

If the value of the assets then continues to decline, liabilities exceed assets.

One firm's liabilities are another firm's assets. For example, if you own Delphi Corporation bonds those are a liability for Delphi but an asset for you.

When the collectability of one firm's liabilities comes into question, such may cause other firms to become insolvent because of the ensuing reduction in value of the asset values of these other firms.

There could come a point at which enough large firms go bankrupt to pull down enough of their creditors in a sort of financial equivalent of a nuclear chain reaction. Economists refer to this as "cascading cross-defaults" or "systemic risk."

A cost as ubiquitous as the cost of energy cannot be increased without limit without extremely unpleasant consequences under any economic arrangement. But a highly leveraged economy embodying a series of implicit multi-billion dollar bets that the price of oil won't crack the triple digit level is more susceptible than an economy with only modest debts. I am skeptical about the extent to which the past investing decisions of the big banks, hedge funds, pension funds and mutual funds embody an accurate appraisal of the effect of hundred dollar a barrel oil on financial asset prices.

I would not care to learn the breaking point, in dollars per barrel, the hard way.

Who would suffer the most with a significant hike is Oil/Gasoline prices. I agree in the short-term the developed world would suffer, but equally we are pretty watseful with energy and have the financial capacity to make a lot of small changes to reduce our enegy bills, directly or indirectly.

Whereas China and India would suffer a double of triple whammy, they would face a rise in the core commidity price and resulting inflation, lose of export markets as US and Eu spending drops and have limited capacity to rapidly adjust to a more fuel effiecnt systems. Maybe that is not a bad thing all round.

I think the biggest risk is inflation, and the fixed attitude that the Fed, ECB and BoE have to interest rates. There is a real risk in the US and to a lesser extent in the UK that High interest rates could be really bad for housing markets and thus the that is worring.
Well, theres a lot to be said for all that, but in short, wether it be people, companies or countries, none should live beyond their means.

... But we all have been.

We've been heading for some type of investment (property) crash for about the last 4 years, and clever changes in monitary and lending policy have seen it off... by allowing people, companies and countries to lend more money.

Theres some buddist saying, "the longer the volcano is controlled, the larger the explosion".

So, i'm waiting for the explosion.


P.S. the same saying goes for sex by the way ;-)
"You can't polish a turd"

Hum arh, they used to tell the tale of back in the days when HM's Navy Ruled the Seas, that for Royal Visits to Battleships a special Loo was set up.
It did not discharge to sea but the Royals 'Droppings' where collected, dried out, Mounted on a Shield, Varnished and Polished up before being placed on Display in the Officers Mess.
Story is Phil the Greek eventually blew the matter wide open so now No Royal ever uses a on board ships Special Lav.
A completely different take on high oil prices from Reuters.

By Jeremy Gaunt, European Investment Correspondent

LONDON (Reuters) - Oil prices are rising again, but the threat to global investments is not what you might think -- deflation of the global economy rather than inflation of consumer prices.

Investors are generally calm about the prospect of spiking crude prices working their way into broad-based inflation and expect interest rates to stay low as a result.

They worry rather that higher prices will drag on economic growth and weaken company profits, in effect deflating relatively robust global economic performance.

"The action is on the economic side of the argument rather than the price side," said Philip Barleggs, head of allocation at Britain's Insight Investment.

One inference of this is that rising oil prices -- U.S. light sweet crude <CLc1> is trading around $67 a barrel -- could be more of a threat to equities, tied as they are to corporate profit growth, than to inflation-sensitive bonds.

Indeed, oil's price rise -- more than 10 percent so far this year -- has been a factor in recent global equity market weakness while helping demand for bonds whenever stocks decline.

"I wouldn't expect it to have a negative impact on bonds, rather the opposite if it were to increase further," said Christel Rendu de Lint, senior fixed income manager at Switzerland's Pictet Asset Management.

"The market is more looking at higher oil prices as a drag on growth rather than being inflationary," she said.

Slowing economic growth would tend to raise demand for safe-haven, fixed-income investments. By contrast, it risks dousing the fire of corporate activity and weigh on equities.


The main reason for the rather laid-back approach to the inflationary side of the ledger is that there has been little sign of it.

Although oil is up sharply over the past few years, inflation in leading countries remains benign and there has been scant carry over from oil to other prices.

At the same time, oil's lack of impact on inflation can be seen in the relative performance of its price and that of the yield on long-term government bonds.

Since the beginning of 2004, the cost of a barrel of light sweet crude has risen around 110 percent. Yields on euro zone debt, by contrast, have fallen and those on U.S. bonds stayed relatively level given the U.S. Federal Reserve's tightening.

Inflation, in other words, is not being priced by investors into long-term interest rates despite the rising oil price.

Like many things, the explanation is globalization. Although higher oil prices act like a tax on both workers and employers, neither is in a position to do much about it.

Industrialized country workers, who in the past would have demanded higher wages as costs rose, find themselves competing with far cheaper labor in China, India and eastern Europe.

Indeed, some of the stellar performance of equities over the past few years has been as a result of wage restraints and labor force reductions prompted by this competition.

But enhanced global competition has also stopped companies from passing on costs to consumers.

"When oil prices rise it adds to the cost of companies while at the same time they cannot increase their selling prices. This hurts profit margins," said Klaus Wiener, head of asset management research for Italy's Generali Group.

"That's why the oil price today works (at) deflation not inflation."


Another factor keeping investors relatively calm about inflation is the rather contradictory belief that monetary authorities will act to snuff out price rises if they do start breaking through from energy into second-round costs.

"We are pretty sure that inflation is not going to rise because the credibility of central banks is so strong," said Benjamin Melman, head of strategy at Credit Agricole Asset Management.

In this vein, some analysts detect a recent change among European Central Bank officials about oil.

"(ECB policymakers) have put their emphasis on the linkage between inflation or price stability risks and oil prices rather than the growth side," said Alessandro Tentori, bond strategist at BNP Paribas.

That could mean higher rates -- not good news for bonds or equities.

And just because all these factors have combined to keep the inflationary impact of higher oil prices in check so far does the mean that will always be the case.

"The lack of pass through has been amazing, but we have to remain careful," Melman said.

The rub is that higher oil prices, by threatening the very global growth that has kept them going strong, could be sowing their own deflationary demise.

"If prices are sustained around $100, oil demand would probably go negative," said Leo Drollas of the Center for Global Energy Studies.

Not much comfort to investors for now.

(Additional reporting by Barbara Lewis and Ana Nicolaci da Costa)

© Reuters 2006. All Rights Reserved.
Jailorinummqasr said:
A completely different take on high oil prices from Reuters.

By Jeremy Gaunt, European Investment Correspondent
christ not a bit of wonder he's a journalist

high oil will cause deflation my hairy ar%e....

For the last few years an inflation cap has been achieved due to offsetting namely by out sourcing production from high costers (europe and america) to low costers namely china (and India). This process is a one shot deal and is now pretty much complete.

Ergo non fuel costs i.e. wages & transport cannot go any lower as they are already in the basement.

Thus any increase in oil price will now increasingly be directly transmitted through to the end product costs, as all other costs are now at the absolute margins.
That's about what I'd expect from the relentlessly optimistic Reuters. If the USA came under atomic attack, they'd be yelling about splendid new investment opportunities opening up in the fields of construction, debris removal, and decontamination.

My reaction to Mr. Gaunt's article is a two syllable Anglo-Saxon expression referring to the male reproductive apparatus.

The proposition that there's been "little sign" of "inflation" (by which he apparently means an increase in the overall level of goods prices expressed in dollars) is a distortion. It is based on the highly politicized, falsified statistics of the US Department of Labor, Bureau of Labor Statistics.

The latter organization, to make a long, complicated story short and simple, lies about inflation because it has a financial interest in doing so. Marginal income tax rates, social security benefits, and collective bargaining agreements are all indexed to the BLS Consumer Price Index.

The notion that rising oil prices are strengthening the bond market by causing a "flight to safety" out of equities is the real point of the article. I assume the purpose is to coax the ill-informed into buying, or at least not selling, US Treasury securities.

US Treasury bond prices aren't being suported by private investment but by central banks eager to avert appreciation of the US dollar against local currencies. They buy up dollars to keep local exports, priced in dollars, cheap to encourage US consumers. They park the dollars they accumulate in the Treasuries market.

The rest of the planet's population thus finances the USA current account deficit and USA purchases of consumer goods

Anybody who imagines that this state of affairs is a sign of strength for the dollar, or the USA or world economies hasn't been paying attention.

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