Fears that Middle East instability would create an energy price shock have proven wide of the mark over the past year. But investors may be thinking about this crisis’ potential risk premium in the wrong way.
Instead of focusing solely on energy prices, they should consider what could happen if an escalating conflict impacts Gulf states’ trillions in global investments.
Crude prices are down almost 20% since before Hamas attacked Israel in October 2023, starting the devastating war in Gaza. The conflict has expanded, as Israel has responded to rocket barrages from Hezbollah, the Houthis and Iran. But the global economic fallout from the conflict has been minimal so far. Container costs rose due to attacks by Yemen’s Iran-backed Houthis on shipping routes in the Gulf, but these costs seem to have been absorbed.
And yet concern remains that the conflagration could widen into a regional interstate war that could draw superpowers into direct confrontation or even elevate nuclear threats. This scenario may seem far-fetched, but many market experts continually cite it as a real under-appreciated risk.
The International Monetary Fund this week called the still-raging conflict a cloud hanging over the world economy, but the organization continued to focus almost exclusively on the potential impact an expanded regional conflict could have on commodity prices.
While there’s little doubt a major supply outage or further shipping disruptions could send energy prices higher, the past year shows numerous counter factors - ebbing Chinese demand, U.S. oil self-sufficiency, Saudi output offsets and the ongoing green energy push.
But the major vulnerability in the region may have moved from the oil market itself to the trillions in dollars in oil windfalls that have been banked and invested far and wide in recent decades. This money has been plowed into everything from Wall Street stocks to Western governments’ bonds, big banks and even sports franchises.
The sovereign wealth funds of the Gulf Cooperation Council, which includes Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates, currently hold combined assets under management in excess of $4.1 trillion.
In short, if even a modest portion of this vast pool of savings had to be repatriated to support damaged local economies or hobbled financial institutions, the impact could reverberate throughout world markets and amplify any commodity hit.
HYPOTHETICAL STRESS TEST
To consider how an escalation of the conflict could affect GCC banks, credit rating firm S&P Global this week drew up four different scenarios ranging from the status quo to a multi-state conflict involving superpowers.
It assumed that a widening war could result in major bank losses - not to mention direct or indirect physical or economic damage. And it’s not hard to see how GCC countries may be forced to tap their rainy day funds.
S&P Global’s analysis suggested the conflict is likely to continue into 2025 but is unlikely to lead to direct and protracted engagement between Israel/U.S. and Iran - and on that basis would likely be modest downward pressure on regional sovereign and bank credit quality.
But the risks balloon in the “severe stress” scenario, which involves fighting between regional and non-regional allies - including Iran, its proxy forces, the U.S. and Gulf allies and possibly other major global actors. S&P said that not only would this lead to significant energy and shipping disruptions, it would also sow macro and fiscal instability across the GCC.
And if that materialized, it could cause massive outflows of overseas funding from GCC banks, domestic capital flight akin to the 1990-1991 Gulf War, and a spike in loan defaults among the banks’ corporate and retail clients.
The ratings firm modeled the potential impact of a “worst case” scenario based on central bank data on external funding at mid-year and asset quality reports from 45 GCC banks.
It found that the region could see 50% outflows of non-resident interbank deposits, 30% outflows of broader non-resident deposits, 20% outflows of private local deposits and a 20% haircut on banks’ domestic investments. What’s more, there could potentially be a 50% increase in non-performing loans.
The domestic deposit outflows could total as much as $275 billion - just under the cumulative $284 billion of available cash or equivalents held at the GCC countries’ central banks.
While this may be manageable, S&P added, it would require liquidation of a portion of these banks’ investment portfolios and government supports.
The wild card is just how much government intervention would be needed and to what extent sovereign wealth funds could be tapped, as that could result in the repatriation of hundreds of billions of dollars invested overseas.
Along with an incalculable human cost, something as devastating as an interstate war would obviously have many unpredictable outcomes, with myriad potential ripple effects impacting regional confidence, travel and capital flows.
The S&P exercise can’t predict what will happen, but it’s useful in that it puts some specifics around what is often vaguely referred to as “escalation” risk.
And it suggests that instead of focusing so much on oil prices, investors should instead consider what could happen to the trillions of dollars in windfall oil savings.
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