Can Middle East insecurity offset the impact of a US slowdown on the oil price?

Last week's dollar decline caught many experts unaware. But with growing evidence of a weakening US economy - lower auto sales, a housing crash, poor manufacturing data, and stagnant consumer sales - something had to give.

Now expect this dollar sell-off to be followed by a correction on Wall Street. This is often the pattern: dollar weakness followed by a sell-off in dollar-denominated assets whose value has thereby fallen against foreign currencies.

Besides, how realistic is the recent Wall Street stock market rally with the US economy under such obvious pressure? Talk of rising corporate profits with a falling economy is surely the stuff of a sucker's rally. Perhaps George Soros was right when he predicted a US recession in 2007 at the start of this year. He also thought housing would be the cause.

Different this time

Normally this kind of economic downturn would be immediately reflected in lower demand for oil and industrial commodities, and therefore lower prices. Indeed, this is a necessary process for an economic recover to occur. But it may be different this time.

Jordan's King Abdullah has warned of three civil wars in the Middle East for 2007: Lebanon, Palestine and Iraq. This represents a further escalation of instability in the region with the implication that the geopolitical risk premium on oil will go up.

There is also a strong possibility that one conflict or another will produce an incident that will spike oil prices to a fresh all-time high, to say nothing of the continued impass over Iran's nuclear program.

1970s example

In the 1970s oil prices remained high, although they did fluctuate considerably, despite the weakness of the industrialized economies which suffered from the high inflation and low growth of stagflation.

However, it has to be said that a drop in oil demand is not usually a signal for higher prices - and that once a geopolitical crisis had subsided there would not be much support for high prices from the demand side in an economic downturn.

This could hasten oil price levels that have not been seen since the last period of economic turmoil that followed the Asian Financial Crisis of the late 1990s. Then oil tumbled below $10 a barrel, a scenario that seems unthinkable seven years later.

Yet history has a habit of repeating itself and most commodities revert to their long-term average mean price, which in the case of oil is $24 a barrel. So perhaps a US slowdown should still be seen as a reminder that oil prices will not stay high forever, and that what has gone up spectacularly in price can also fall in just such a spectacular fashion.