S&P Examines the Effect of a Major Oil-Supply Disruption

Standard & Poor's

Although the U.S. economy has been able to absorb higher energy prices so far, it has become more sensitive to costlier oil now than it was a year ago, according to a report by Standard & Poor's Ratings Services. The article, which is titled "Conflict In The Mideast: Four Oil Supply Scenarios," says that accordingly, any major disruption on oil supplies, particularly in the Middle East region, could have an impact on the U.S. and global economy.

Standard & Poor's expects the economy to slow down to a 2.5% GDP growth pace in 2007 from an estimated 3.5% in 2006, and the falloff in U.S. growth means it takes a smaller shock to cause a recession than it did a year ago.

"Whether the current Mideast conflict causes a recession depends mostly on how big the impact on oil supplies and prices becomes," explained Standard & Poor's Chief Economist David Wyss. "But this is still highly uncertain. At Standard & Poor's, we continue to believe that the most likely outcome is that cooler heads will eventually prevail and that oil prices will drop back from current peaks."

Standard & Poor's examined four different scenarios, but even worse cases--or combinations of the problems described below--are possible. The four scenarios are:

--The conflict is contained. The current fighting subsides without spreading to Syria or Iran. Oil prices subside to $70/barrel by year-end.
--Iran shuts its taps. The conflict spreads to Iran, perhaps because of air strikes by Israel or the U.S. on nuclear or other facilities. Iran stops exporting oil. However, the Strait of Hormuz, through which most Persian Gulf oil flows, remains open, and Arab states continue to export.
--The Gulf goes dry. As in the second scenario, except that Iran partially closes the Strait of Hormuz. Most Persian Gulf oil shipments are shut down for a period of six months before the vital shipping lane reopens.
--The U.S. gets cut off. The Persian Gulf countries join in a selective embargo of the U.S., refusing to export oil to the world's biggest energy consumer but continuing to supply it at similar volume to Asia, Europe, and other oil-importing regions. Venezuela cooperates with the Arab embargo.

"Standard & Poor's base case assumes that the fighting is limited to Israel, Palestine, and Lebanon," Wyss added. "There is no impact on oil supplies, and prices drop slowly from current levels, which have a risk premium built into them."

"Again, worse cases than any of these are entirely possible, with resulting impacts on the U.S. and world economy that are nearly impossible to model. The best hope is for a diplomatic breakthrough--and a little luck--to help limit the outcome to the first scenario," Wyss concluded.