The Sword of Damocles

An economic worst-case scenario for the Israeli-Palestine war (free)

From Tuomas Malinen’s Forecasting Newsletter.

This week my subscribers will receive two entries in compensation for the missed post two weeks ago (apologies). Both of them deal with the economic collapse, which is already on its way (as explained in the second entry), but it could be made much, much worse through the escalation of the Israeli-Palestinian conflict. In this first entry for the week, I deal with the (economic) worst-case scenario of the conflict.

On Tuesday, I published a post on X (Twitter), which summarized the worst-case scenario. It included 10 points:

1. The conflict escalates into a regional war with the U.S. becoming directly involved.

2. OPEC responds with an oil embargo.

3. Iran closes the strait of Hormuz.

4. The price of oil reaches $300/barrel.

5. Europe succumbs into a full-blown energy crisis due to LNG shortage.

6. Massive spike in energy prices reinvigorates inflation with central banks responding accordingly.

7. Financial markets and the global banking sector collapse.

8. Debt crisis engulfs the U.S. forcing the Federal Reserve to enact yet another financial market bailout.

9. Petrodollar trade collapses.

10. Hyperinflation emerges.

In this entry, I go through each step.

History rhymes?

In October 1973, Israel fought the Yom Kippur War against a coalition of Arab States led by Egypt and Syria. As a result of this, the Organization of Arab Petroleum Exporting Countries proclaimed an oil embargo against western countries supporting Israel. In six months, the price of oil rose by nearly 300%, globally, and even more in the U.S., which at that time had become dependent on the Middle-Eastern oil.

In the current time, in the worst-case, Israel launches a major counter-offensive against Palestine leading to a declaration of war, to Israel, from Iran and Syria (others may join too). In this situation, the U.S. would be almost surely forced to respond and take part in the defense of Israel. The Ford carrier strike group (which includes world’s largest warship, USS Gerald R. Ford) has been dispatched to eastern Mediterranean and the Biden administration has been reported of considering sending another carrier strike group to eastern Mediterranean. There are also rumors of U.S. military cargo planes making routine trips to Israel.

Any direct U.S. involvement in the war would almost surely force a response from the Organization of Petroleum Exporting Countries, or OPEC, or at least from some of its members. This would, most likely, take the form of an oil embargo to the U.S. and possibly Europe.

The strait of Hormuz is a pivotal, narrow strait for the global oil markets. One-sixth of all oil and one-third of all liquified natural gas, or LNG, consumed in the world passes through it. The strait includes eight islands of which seven are controlled by Iran, but it has a military presence in all eight. Thus, Iran has the military capacity to close the strait.

The means of closing the strait are plenty. Essentially, they range from a threat-based closing, where Iran threatens to sink any tanker passing through it, to actual sinking of a super-tanker into the strait closing it for an unknown period of time and also polluting the Persian Gulf. However, as close to 85% of Iranian imports pass through the strait, the latter option can be considered unlikely.

If the closing, or even a disruption of traffic through the strait of Hormuz would occur, with the Russian oil and gas embargo continuing, we would most likely, see the global prices of oil and LNG skyrocket to never-before-seen heights. This would reinvigorate rapid inflation, but there would also be more serious repercussions.

The Achilles heel of Europe

After closing most of the pipelines delivering Russian gas to Europe, the continent has relied on the global LNG market to fill the gap. Most importantly, Europe has relied both U.S. and Middle-Eastern sources for gas deliveries.

For example, Germany just signed a contract with Oman LNG for gas deliveries, which pass through the strait of Hormuz. Germany has also signed an agreement with U.S. based Venture Global on LNG deliveries making it the largest provider of LNG to Germany. However, VG has not even yet started building the facility where gas to Germany is delivered from.

The U.S. has accounted for little over half of Europe’s LNG demand during the past year, with Russia and the Middle-East providing around 30%. If both of these latter sources were cut, or their supply seriously reduced, it’s unlikely that the U.S. or other sources could fill up the gap, because the global LNG market is undersupplied. Moreover, combining Middle-Eastern (and possibly Russian) gas cutoff with a normal or a cold winter could create an utterly devastating conditions for the already “finely balanced” European gas market.

This means that the Israel-Palestine conflict has the capacity to derail all plans for energy security in Europe, as Russian gas has been cut (and blown) of. It’s hard to overstate the seriousness of this threat with German and European economies already sinking into a recession. Return of the energy crisis (with vengeance!) would most likely strike a mortal blow to the European economy and topple her banking sector with known global consequences.

From financial chaos to hyperinflation

Naturally, reinvigorated inflation pressures would force central banks to enact another round of interest rate rises. This would wreak havoc among consumers and corporations, but also in the capital markets. Yields of sovereign debt would likely explode. This would be followed by an utter collapse of asset and credit markets, á la spring of 2020.

At this point, we would most likely see the central banks take their “monetary perversions” to another level. This means that while they would be raising interest rates to quell inflation, they would also enact asset purchase programs to support the sovereign debt, credit and asset markets. The bailout of the financial markets would need to reach several trillions of USD, like during the spring of 2020. This would push a vast amounts of money and especially U.S. dollars into the global economy. This would naturally increase inflation pressures massively, but there’s a risk something even worse.

As a ‘nuclear option’, OPEC could stop using USD in the oil trade altogether. This would mean that the demand for dollars would suddenly collapse, and the “excess dollars”, formerly used to purchase oil, would eventually head home. This would create an unprecedented spike in the money supply of the U.S. creating perfect conditions for hyperinflation with collapsing production due to a deep recession fueled by rapid inflation, high interest rates and a banking crisis. Havoc in the U.S. economy, and thus the world, would be nothing short of apocalyptic.

Conclusions

As I am finalizing this, first reports of missile strikes to Israel from Hezbollah have surfaced in X (Twitter). At this point, it’s impossible to confirm or debunk these claims. If these have occurred, we have just taken steps to reach the first point of the worst-case scenario.

In any case, the scenario outlined above underlines the seriousness of the situation we currently find ourselves in. The Israeli-Palestinian conflict has the capacity to 1) deliver an energy checkmate for Europe and 2) initiate a devastating collapse of the U.S. economy.

However, it should be noted that, while it’s currently unlikely that we see all 10 points come to pass, if we reach even the first points, they would deliver a crushing blow to the fragile global economy. That’s why the situation needs to be followed very closely.

Regardless, it may not be a bad idea to buy gold, gasoline, gas and wood (if you have a stove). We will continue to provide guidance for preparation in GnS Economics Newsletter.

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Disclaimer:

The information contained herein is current as at the date of this entry.  The information presented here is considered reliable, but its accuracy is not guaranteed.  Changes may occur in the circumstances after the date of this entry and the information contained in this post may not hold true in the future.

No information contained in this entry should be construed as investment advice.  Readers should always consult their own personal financial or investment advisor before making any investment decision, and readers using this post do so solely at their own risk. 

Readers must make an independent assessment of the risks involved and of the legal, tax, business, financial or other consequences of their actions. GnS Economics nor Tuomas Malinen cannot be held i) responsible for any decision taken, act or omission; or ii) liable for damages caused by such measures.