Since the Iran war began, financial markets have shown faith that Trump and the ayatollahs will bring the war to a speedy conclusion. Oil prices have, so far, only increased by about 50 per cent – modest in the circumstances.
However, I don’t have the same faith as financial markets in the wisdom of the US president. So I believe that Ireland, and the wider EU, should prepare for the real possibility that the Strait of Hormuz remains closed for much of 2026.
This would likely entail a 15 per cent reduction in world oil supplies. In turn, to ensure that demand for oil equals supply, it would mean a further huge rise in oil prices.
Two weeks ago, experts from The Economist examined the academic evidence on how high prices would have to go to clear the oil market. Based on previous experience, the literature suggests that prices would have to rise to somewhere between $170 and $460 a barrel to clear the market, an increase of between 150 per cent and 500 per cent.
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Because of differences in the type of oil produced in different regions, price increases for diesel, aviation fuel, and heating oil may be even higher.
In the 1970s oil crisis, a real increase in prices of 500 per cent resulted in a 15 per cent reduction in consumption, but it took quite a number of years to achieve that outcome.
Early in the current crisis, Fatih Birol, head of the International Energy Agency, warned that the world could be facing the worst energy crisis since the second World War. That may prove to be prescient. To date, there has been little public discussion here, or in Europe, on the implications of such a big shock to the world economy. The Department of Finance’s recent spring statement looked at a worst-case scenario of an oil price of $150 a barrel, a fair bit below the minimum hit that the academic literature suggests.
The huge rise in oil prices would be needed to clear the world market because oil is so essential to modern life: alternatives take time to develop. The scale of reduction needed to bring demand back into balance with supply may involve pushing the world economy into recession.
In 2020, as a result of Covid-19, world gross domestic product fell by 3 per cent, producing an immediate 7 per cent fall in world oil consumption.
The impact on poorer countries in Africa and Asia would be much worse than in Europe, as we could afford to pay the higher prices, even if it proves very painful.
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A continuing closure of Hormuz could mean the cost of our energy imports rising by a minimum of about €10 billion, or more than 3 per cent of national income. In turn, we would see a dramatic rise in consumer prices of 5 per cent or more, making us all much worse off.
This would be compounded by the impact of a world economic recession. Previous Economic and Social Research Institute modelling suggests a fall of 3 per cent in world output would lower Irish national income and consumption by at least 3 per cent in real terms, costing jobs, with a knock-on hit to tax revenue.
To protect those on low incomes from exceptional inflation, and to pay for higher unemployment, the welfare bill would balloon. Depending on how high oil prices go, this could necessitate Government borrowing next year. These are crude but shocking numbers: you would need an economic model to do the job comprehensively.
Given a hit to the economy of €10 billion or more through higher energy imports, there would be no way that the Government could offset it. Protests, as we saw in April, would be futile as the problem would be Trump, not the Irish Government.
While I hope that oil begins to flow again this month, and that the crisis abates, the job of the Government is to prepare Ireland for the real possibility of a very traumatic economic shock.
In the immediate future, the Government needs to keep its powder dry to deal with such a possible recession. Talk of tax cuts in the next budget is a dangerous distraction. If the worst happens, the job of the Government will be to help develop a sense of national solidarity, as in the case of Covid-19, where economic suffering is equitably shared and the limited Government support possible is concentrated on those who are exceptionally vulnerable.
Hopefully, Trump will see sense and the current crisis will pass, although even then, the situation will take time to unwind. But we also need to be prepared in case any deal struck doesn’t stick. Trump has form in that regard.
