In every major economy, finance ministers are asking the same question: how high can oil prices go, and how long can they stay, before recession becomes inevitable? This time last week, energy markets were pricing in a scenario in which attacks on Iran by the US and Israel would be followed by a relatively short conflict. But after a week of retaliatory attacks by Iran on energy infrastructure in other Gulf states, and the election of a hardline supreme leader by the country’s clerics — Mojtaba Khamenei, son of the former Ayatollah, is the new head of state – Energy prices now reflect expectations of a longer war. The price of Brent crude rose briefly above $115 a barrel this morning and G7 finance ministers will meet later today to discuss releasing oil reserves to help control rising prices.
The longer the price of oil remains elevated, the more it has to fall again. A boom created by market trade may be short-lived, but a price raised by the physical reality of reduced production capacity, or depleting oil reserves, is harder to reverse. The change in the energy markets this morning may reflect the movement of oil prices from one type of movement to another – from being affected by the threats and promises of politicians, to being affected by the concrete problems that the war is creating for infrastructure, ships and insurance.
What does this mean for the UK, a net importer of energy? As a member of the International Energy Agency (IEA), the UK is required to hold oil reserves equivalent to 90 days worth of net imports or 67.5 days of oil use (the numbers are different because we produce some of our own oil). This is held by the oil companies, not the government, and can be issued in coordination with other IEA members to lower prices on the global market. This was last used in 2022, and while it works, it is a temporary measure.
How long will it take for oil prices to affect the UK economy? Paul Donovan, global chief economist at UBS Wealth Management, said that if prices remain elevated for three months, British consumers will quickly notice price increases on some frequent purchases (especially petrol) and may talk about feeling worse, but they will also make their own efficiencies, such as saving less each month, cutting back on spending or driving more slowly. Within that time, he said, most people won’t make major changes to their spending (such as canceling vacations) and most businesses won’t make significant changes to their plans, but after three months, that could change.
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However, if higher prices persist for five or six months, more significant changes will occur as the energy shock translates into real inflation and real changes in consumer spending and business investment. That means Keir Starmer’s government has weeks to decide on an unenviable choice: either the country’s economic growth or the government’s finances will have to take a hit.
South Korea has already made this decision and will set a price cap for oil products. This means that the South Korean government will subsidize energy prices, so consumers feel less of an impact and the damage is done to the government’s finances rather than the economy.
In 2022, for all the Liz Truss ministry’s talk of small government, she made the same choice, committing to a hugely expensive energy subsidy programme. This was partly paid for by the surprise tax on oil and gas producers that had been implemented by Rishi Sunak, but Truss also used very large amounts of public borrowing, which made her other plans for the economy (which relied even more on borrowing) unworkable and explosive.
Rachel Reeves and Starmer now face a grim dilemma. They could save the government from further spending and let consumers take the hit, but that would end up affecting public finances anyway, through lower tax revenues, and no government wants to let the country slide into recession. So they could provide energy bills and help people keep costs down, which could save the economy, but that would derail their plans to reduce debt – and there’s always the question of how much extra borrowing the gilt market would accept.
The only way to escape higher borrowing or recession would be to impose higher taxes. The most obvious of these would be a bigger windfall tax on oil and gas giants that would bring much higher profits from higher prices, but the energy sector will argue that this will hinder investment in Britain’s future energy security.
In 2022, economist Isabella Weber’s study showed that the richest 1 percent of Americans received $48.8 billion in “fossil fuel profits” between April and June alone. The higher prices Americans were paying for food and fuel meant wealth was being transferred from the working class to the plutocracy at a rate of more than $500 million a day. What Weber’s research illustrates is that if you don’t cap prices, the cost burden falls mostly on people who have less money (because they spend a larger share of their income). Inflation is a tax, perhaps the most basic tax there is, and the fiscal policy that allows it to rise is a tax increase by any other name.
The Iran war is in economic terms the latest tax hike imposed by Donald Trump on consumers in the US and around the world. The wealthiest 1 percent of Americans can thank it for that, but governments elsewhere will have to devise less painful means to pay for it.
(Further reading: Dubai at war)
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