In every major economy, finance ministers are asking the same question: how high can oil prices go, and how long can they be sustained, before recession becomes inevitable? This time last week, energy markets were pricing in a scenario in which the attacks on Iran by the US and Israel would be followed by a relatively short conflict. But after a week of retaliatory strikes by Iran on energy infrastructure in other Gulf states, and the choice of a hard-line 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 oil rose briefly above $115 a barrel this morning, and the finance ministries of G7 countries will meet later today to discuss releasing petroleum reserves to help keep price rises in check.
The longer the oil price remains elevated, the longer it takes to come back down. A spike created by trades in the market can be brief, but a price driven up by the physical reality of production capacity being cut, or oil reserves being depleted, is harder to reverse. The change in energy markets this morning may reflect the oil price moving from one type of movement to the other – from being affected by the threats and promises of politicians, to being affected by the concrete problems the war is creating for infrastructure, shipping and insurance.
What does this mean for the UK, a net energy importer? As a member of the International Energy Agency (IEA), the UK is obliged to hold oil stocks equivalent to either 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 oil companies, not the government, and it can be released in a coordinated way with other IEA members to bring down prices in 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 make a dent in 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 rises in some frequent purchases (especially petrol), and may talk about feeling worse off, but they will also make efficiencies of their own, such as saving less each month, cutting back slightly on spending, or driving more slowly. Within that time, he said, most people won’t make major changes to their spending (such as cancelling holidays) and most businesses won’t make significant changes to their plans, but beyond three months, this could change.
If higher prices last for five or six months, however, more significant changes will take place as the energy shock translates into real inflation and real changes in consumer spending and business investment. This 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 introduce a price cap on petrol products. This means the South Korean government will subsidise energy prices, so consumers feel less of an impact and the damage takes place in the government’s finances rather than the economy.
In 2022, for all the Liz Truss ministry’s talk of small government, it made the same choice, committing to a hugely expensive energy subsidy programme. This was paid for partly by the windfall tax on oil and gas producers that had been implemented by Rishi Sunak, but Truss also made use of very large amounts of public borrowing, which made her other plans for the economy (which relied on even more borrowing) unworkable and explosive.
Rachel Reeves and Starmer now face a grim dilemma. They could save the government from further expense and allow consumers to take the hit, but this would end up affecting the public finances anyway, through lower tax receipts, and no government wants to allow the country to fall into recession. So they could underwrite energy bills and help people to keep spending, which might preserve the economy, but this would scupper their plans to reduce debt – and there is always the question of how much additional 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 greater windfall tax on the oil and gas giants that will make much higher profits from higher prices, but the energy sector will argue that this will deter investment in Britain’s future energy security.
In 2022, research by the economist Isabella Weber showed that the wealthiest 1 per cent of Americans had received $48.8bn in “fossil fuel profits” between April and June alone. The higher prices Americans were paying for food and fuel meant that wealth was being transferred from the working class to the plutocracy at a rate of more than $500m a day. What Weber’s research illustrates is that if you do not cap prices, the cost burden falls mostly on people who have less money (because they spend a greater proportion of their income). Inflation is a tax, perhaps the most fundamental tax there is, and fiscal policy that allows it to rise is a tax hike 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 richest 1 per cent of Americans may thank him for it, but governments in other countries will have to decide the least painful means to pay for it.
[Further reading: Dubai at war]
Content from our partners
Related
Join the debate
Subscribe here to commentUm, if rising oil prices are a tax hike how is raising taxes gonna counteract that? Both are contractionary.