Geopolitical Radar Extra: Contagion Risk from Middle East is Significant

Geopolitical Tensions and Escalation Risks

The ongoing conflict in the Middle East is intensifying, highlighting the inherent difficulties in controlling and resolving armed conflicts. While not the most probable outcome, a protracted war scenario should be considered, with potential ramifications extending across the Middle East and North Africa (MENA) region, and possibly impacting parts of Europe.

Disruptions to supply chains are anticipated, leading to price increases not only for crude oil and natural gas but also for fertilizers. A prolonged crisis elevates the risk of a sustained inflation shock. Furthermore, Europe could face a notable negative impact on economic growth.

Despite recent increases in short-term market inflation expectations, major central banks are unlikely to respond with interest rate hikes. Such a response would be inappropriate, as this situation represents a classic negative supply shock that is beyond the control of monetary policy. Crucially, longer-term inflation expectations remain anchored.

Economic Consequences and Supply Chain Vulnerabilities

The conflict's impact extends beyond oil and gas, affecting critical sectors like fertilizer production. The Persian Gulf region accounts for an estimated 25-35% of global nitrogen fertilizer exports, heavily reliant on maritime routes through the Strait of Hormuz. Limited alternative routes exist, raising concerns about supply disruptions.

Farmers, particularly in the Northern Hemisphere, typically purchase fertilizers between March and May before the planting season. Rising prices could lead to delayed or reduced purchases, negatively impacting crop yields and ultimately driving up food prices.

Approximately 20 million barrels per day, about 25% of global seaborne oil trade, passes through the Strait of Hormuz, with 80% destined for Asia, according to the IEA. Alternative pipeline capacity ranges from 3.5 to 5.5 million barrels per day. Several countries, including Kuwait, the UAE, and Iraq, have reportedly begun reducing oil production due to the effective closure of the Strait of Hormuz. Operations at Saudi Arabia's largest refinery, Ras Tanura, have been suspended following a drone strike. Brent crude topped USD 90 on Friday and is expected to climb further.

Regarding natural gas, around 93% of Qatar's and 96% of the UAE's LNG exports transit through the Strait, representing 19% of global LNG trade. Unlike oil, there's no alternative route for LNG. Recent attacks on key sites have halted Qatari LNG production for several days. Europe's gas inventories are already low, and refilling them at higher prices will impact consumers next winter, even if de-escalation occurs.

Central Bank Response and Regional Instability

The European Central Bank (ECB) and other major central banks are unlikely to react to war-induced commodity price increases with interest rate hikes. This situation constitutes a negative supply shock beyond their control, and longer-term inflation expectations remain stable. A premature tightening of monetary policy could exacerbate the economic downturn.

Tensions are escalating across the MENA region, with several European countries already involved to some extent. The United Kingdom is providing base access to the United States, France has pledged to support the U.S. in securing navigation in the Strait of Hormuz, and Turkey and Greece are increasingly at odds in Cyprus. These factors contribute to a complex and volatile geopolitical landscape.