Today's fragile global economy faces many risks: the risk of another flare-up of the Eurozone crisis, the risk of a worse-than-expected slowdown in China and the risk that the economic recovery in the US will fizzle out (yet again). But no risk is more serious than that posed by a further spike in oil prices.
The price of a barrel of Brent crude, which was well below $100 in 2011, recently peaked at $125. Petrol prices in the US are approaching $4 per gallon, a further damage to consumer confidence, and this will increase further during the high-demand summer season.
The reason is fear. Not only are oil supplies plentiful, but demand in the US and Europe has been lower, owing to the decline in use of vehicles in the last few years as well as weak or negative GDP growth in the US and the Eurozone. Simply put, increasing worry about a military confrontation between Israel and Iran has created a "fear premium".
The last three global recessions (prior to 2008) were caused by a geopolitical shock in the Middle East that led to a sharp spike in oil prices. The 1973 war between Israel and Arab states led to global stagflation (recession and inflation) in 1974-1975. The Iranian revolution in 1979 led to global economic decline in 1980-1982.
And Iraq's invasion of Kuwait in the summer of 1990 led to the global recession of 1990-1991.
Even the recent global recession, though triggered by a financial crisis, was exacerbated by spiking oil prices in 2008. With the barrel price reaching $145 in July of that year, oil-importing advanced economies and emerging markets alike faced a recessionary tipping point.
The risk that Israel's threat to attack Iran's nuclear installations will, in fact, lead to an outright military conflict may still be low, but it is growing.
Israeli Prime Minister Benjamin Netanyahu's recent visit to the US demonstrated that Israel's fuse is much shorter than the American's. The current war of words is escalating, as is the covert war that Israel and the US are allegedly engaging in with Iran (including the killing of nuclear scientists and the use of cyber warfare to damage nuclear facilities).
Iran, with its back to the wall as sanctions bite harder (especially the recent SWIFT and central bank restrictions, and Europe's decision to stop importing Iranian oil), could react by increasing tensions in the Gulf.
Eventually, it could easily sink a few ships to block the Strait of Hormuz, or unleash its proxies in the region.
Recent attacks on Israeli embassies around the world appear to signal Iran's reaction to the covert war being waged against it, and to the tightened sanctions, which are aggravating the effects of the regime's economic mismanagement.
Likewise, the recent escalation in cross-border fighting between Israel and Gaza-based Palestinian fighters could be a sign of things to come.
The next few weeks could bring a reduction in tensions, as the US, France, Germany, UK, China, and Russia go through another round of talks in an attempt to discourage Iran from developing nuclear weapons or the capacity to produce them. But if this attempt fails, as is likely, one cannot rule out that by summer, Israel and the US agree that, sooner than later, force will have be used to stop Iran.
While Israel and the US still disagree on some points, Tel Aviv wants the strike to take place this year. But the Obama administration is opposed to military action considering the presidential elections coming up in November.
Most importantly, the US is now clearly rejecting containment (accepting a nuclear Iran and using a deterrence strategy). So, if sanctions and negotiations don't work, the US may have to start military action against Iran.
The US is now providing bunker-buster bombs as well as refuelling planes to Israel while the two armies are increasing joint military exercises in case an attack becomes necessary and unavoidable. If the drums of war grow louder this summer, oil prices could rise in a way that will most likely cause a slowdown in US and global growth. It may even lead to an outright recession if a military conflict erupts and sends oil prices soaring.
Moreover, broader geopolitical tensions in the Middle East are not fading, and might intensify. Aside from deep uncertainty regarding the course of events in Egypt and Libya, now Syria is on the verge of civil war, and radical forces may get an upper hand in Yemen, undermining security in Saudi Arabia.
There is still concern about political tensions rising in some Gulf states and potentially even in Kuwait and Jordan — areas with substantial Shia populations.
Now that the US has left Iraq, rising tensions between Shia, Sunni, and Kurdish factions do not bode well for the country's ability to boost oil production soon.
There is also the ongoing Israel-Palestine conflict, tension between Israel and Turkey, and hot spots — particularly Afghanistan and Pakistan — in the wider neighbourhood.
Oil is already well above $100 per barrel, despite weak economic growth in advanced countries and many emerging markets.
The fear premium might push prices significantly higher, even if no military conflict ultimately takes place, and could trigger a global recession if one does.
— Project Syndicate, 2012