The Best- and Worst-Case Scenarios of Iran’s Strait of Hormuz Closure

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The current energy crisis, luckily, will not usher in a return to the inflation-laden economy of the 1970s.

The war in the Persian Gulf—whether one supports the effort or not—presents all sorts of frightening prospects. News of negotiations briefly offers hope of an end to destruction and a clear path forward, while denials that talks have begun dash those hopes. As long as the fighting continues, it is hard to see an end to the Iranian blockade of the Strait of Hormuz, much less allow an assessment of the conditions that might ultimately impinge on shipping there. Possibilities—good, bad, and ambiguous—seem endless.

For business and the economy, however, some things are certain. The closure of the Strait of Hormuz has, for the time being, denied the world some 20 percent of its seaborne oil and natural gas supplies. That includes every bit of Iran’s production, just about all of it going to China, but also much Saudi, Kuwaiti, Qatari, and Emirati oil and gas, most of it going to Europe, Japan, and elsewhere in Asia. The other stark fact is how oil and natural gas prices have soared. The price of a barrel of West Texas Intermediate (WTI) has risen over 60 percent from $62 in mid-February to just over $100 at the time of writing. Bent crude has seen its price rise by a comparable percentage, approaching $110 a barrel.

These matters have unleashed a torrent of scare stories in media outlets that variously envision debilitating inflation akin to what happened in the economically bleak 1970s, the end of any hope for more affordable lifestyles, recession, and stagflation. All of these, of course, are completely plausible, but much else in this admittedly uncertain situation points to less dramatic and less frightening economic repercussions.

It is, for instance, easy to dismiss a rerun of the oil-short, stagnant, and inflationary 1970s. Then, an oil embargo imposed by the Organization of the Petroleum Exporting Countries (OPEC) and the resulting shortages created a widespread sense that oil would become increasingly scarce. Phrases like “peak oil” were popular. This sense of scarcity created an expectation that, however long the gas lines were, they would only get longer, and however high oil prices rose, they would only rise further. Such expectations put much additional upward pressure on the overall rate of inflation and, accordingly, still more downward pressure on the economy. The ensuing momentum—up and down—created by these expectations made it difficult to secure inflation relief and reinvigorate the economy, even when immediate pressures subsided.

Little of this is the case today. Astounding efficiencies on fuel use, new drilling technologies, and the growing presence of alternatives have scotched all talk of “peak oil.” Indeed, for better or worse, people in North America today have a sense of oil and natural gas abundance. What is more, there is a growing sense that North American supplies will quickly find their way into world markets and that, even if the Strait of Hormuz were closed permanently, oil producers on the Arabian Peninsula would construct pipelines and port facilities to bypass the strait. 

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Though it might take years for these fuel sources to become widely available, the very real prospect of such supplies removes the kind of permanent scarcity expectations that dominated the 1970s, created such an inflationary momentum at the time, and weighed so heavily on economies across the world.

Potentially, there is another big difference from the 1970s. Back then, the Federal Reserve and other central banks tried to mitigate the real economic burdens of oil shortages by pursuing easy monetary policies. They poured money into their respective economies and, in doing so, exacerbated the inflationary effects of rising oil and gas prices. 

Had the Fed and other central banks resisted this temptation, fuel prices would have risen and pushed up measured inflation rates, but the absence of monetary largess would have held back the prices of other products and mitigated the general inflationary impact of the oil price hikes. This time, the Fed and other central banks seem aware of past mistakes, as recent decisions to hold interest rates steady suggest. Should the Fed remain vigilant in this regard, a rise in oil prices would still add to inflation, but not in the fundamental, persistent way seen in the 1970s.

If the horrors of the 1970s loom less large than they might, still a backdrop of open warfare makes it impossible to settle on secure likelihoods. The best any honest analyst can offer are pictures of the best and worst possibilities, recognizing that reality will likely fall between them.

The most pleasant possibility would be an early end to hostilities. It would include negotiations with a cooperative or at least less belligerent government in Iran, one brought on by either a successful public uprising or a chastened rump of the existing regime. The Strait of Hormuz would promptly reopen to all shipping, and strenuous efforts would be made to repair the damage already done to the region’s oil and gas fields as well as to shipping infrastructure. 

Such repairs would, of course, take time, but the oil would at least begin to flow, and the world would, in such circumstances, position itself for a greater future flow. Prices would fall from today’s highs. Indeed, since such an outcome would remove the long-standing disruptive influence of the old Iranian regime, oil prices could eventually fall below pre-war levels. Oil producers, most especially the Russians, would suffer in such a reality. Still, most of the world’s economies would benefit, especially if the Fed resisted the temptation to make the mistakes of the 1970s and so quickly erased any lingering inflationary momentum.

The most painful alternative would see extended fighting and a complete destruction of oil and gas fields in the region, as well as shipping infrastructure. The world would indefinitely lose access to all the oil and gas that once passed through the Persian Gulf, as well as from other facilities in the region. Fossil fuel prices would climb much higher than they are today, and matters would leave all economies with little reason to look for price relief in the foreseeable future. North American supplies would, in time, flow more completely into world markets, but not likely in enough abundance to erase the Middle Eastern losses. Worse, the Fed could relapse into the unfortunate practices of the 1970s and, in so doing, generalize and extend the immediate inflationary effects of rising oil and natural gas prices. 

As of this writing, betting markets estimate an almost 80 percent chance that the fighting will cease by the end of June. If that works out, probabilities point directly to the happy scenario above, more in its direction than to the worst-case scenario. Still, such betting is hardly authoritative. While the fighting continues, it would be unwise to dismiss the above worst-case scenario or something like it.

About the Author: Milton Ezrati  

Milton Ezrati is a contributing editor at The National Interest, an affiliate of the Center for the Study of Human Capital at the University at Buffalo (SUNY), and chief economist for Vested, a New York-based communications firm. His latest books are Thirty Tomorrows: The Next Three Decades of Globalization, Demographics, and How We Will Live and Bite-Sized Investing.

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© The National Interest