Consider This: With Middle East escalation and oil price spikes, what’s next?

The outbreak of military conflict between Israel and Iran introduces significant uncertainty into the global economy and capital markets, as reflected in recent volatile bond, stock, energy and currency market moves. Investors are justifiably concerned that the conflict could spread, putting at risk global energy supplies and pinching key global transport routes, adding to other sources of geoeconomic uncertainty.

Among the greatest concerns is the potential for spiking oil prices to spur a return to high inflation. As we summarize below, however, the risk of 1970s-style inflation spurred by higher oil prices is relatively low, in our view.

The 1970s

The Great Inflation of the 1970s lasted from 1965 to 1982 and triggered a long, painful period of unemployment and recession. Its legacy was etched on the memory of a generation of central bankers and investors and studied by the following generation.

Contemporary analyses attributed the episode to a range of factors including the Organization of Petroleum Exporting Countries’ (OPEC) oil embargo, corporate greed and resolute union leaders.  Importantly, however, inflationary pressures were already present before the 1970s oil price shocks. In the United States, inflation was 5.8% in 1970, as the government spent large sums on the Vietnam War and increased welfare payments. In Japan, it was 6.4%. In the United Kingdom, inflation was 9.4% in 1971. The peaks came in 1974 (European Union [EU]: 13%, Japan: 23%), 1975 (United Kingdom: 24%), and 1980 (United States: 13.5%).¹

It is, of course, correct that in 1973, OPEC embargoed oil exports to the United States and European countries, making prices spike up to 400% in days, leading to rationing and triggering a widespread recession in these regions.

However, the link between inflation and oil prices is tenuous, as shown by the Federal Reserve Bank of Dallas.²

• Geopolitically driven OPEC oil supply disruptions fail to explain the increases in the price of oil.
• Structural models that allow for both demand and supply shifts in global oil markets indicate that oil demand shocks largely drove these oil price increases.
• Broader inflationary pressures also explain similar surges in other industrial commodity prices (e.g., paper and pulp, scrap metal, lumber) in the early 1970s. These increases predated the surge in the price of oil, given the regulatory and contractual constraints on the price of oil at the time.

The argument is that oil price increases reflect surges in global demand for industrial commodities ultimately caused by expansionary monetary policy. This would suggest that rising oil prices were a symptom rather than the cause of high US inflation in the 1970s. Not only did US inflation share a common demand component with oil prices, but higher US inflation motivated increases in the price of oil in 1973/74, as OPEC oil producers saw their real foreign exchange earnings erode as the US dollar weakened.

2025

Today’s situation is different in any case. The United States is the second-largest oil exporter in the world, while Iran produces much less than the United States³ and consumes about half of it domestically, leaving only half for export. Further, Iran’s biggest customer, China, pays fixed prices in advance, so there is no benefit to Tehran from a spike in oil prices.

Further, in the 1970s, the benchmark inflation basket commonly tracked across the United Kingdom, Europe and the United States contained oil, kerosene and paraffin for transportation fuel, industry, shipping and residential heating, making it a significant household expenditure item. Today, over half of new car registrations in Europe and China are electric or hybrid electric. The EU generates 48% of its electricity from renewable sources, the United Kingdom 58%,⁴ China 37%⁵ and the United States 40%.⁶ If we look for the biggest dependencies on oil/gas and other fossil fuels, we find Saudi Arabia (99%), Iran (92%), United Arab Emirates (74%) and Russia (64%).⁷

Meanwhile, OPEC is steadily raising output to regain lost market share. Early indicators suggest OPEC’s new strategy is having the desired impact of stimulating new demand in Asia while disincentivizing investment in new production outside OPEC.

Arguably the most important long-term factor behind the shift in global importance of the price of oil is that China’s once-rapidly rising demand for fossil fuel imports appears to be peaking across several energy sources, especially crude oil, but also potentially coal and gas. As a result, China may soon join Europe and North America as the third major global economic region to experience a peak in fossil fuel imports. China’s emissions may have peaked thanks to its clean power boom.

As a result, global demand growth for oil going forward will likely be much lower, as other major emerging economies, especially India, will not fully make up for the loss of China’s past growth, in our view.

This could be positive for regions that rely on fuel imports, including Northeast Asia, Europe and India, while it could pose a fiscal challenge for producers, including OPEC states and Russia.

For the United States, lower growth in demand for oil would have a mixed impact, as the nation is the world’s largest oil and gas producer but also the biggest consumer of energy.