Striking Iran, but hitting Latvia: how the war in the Middle East affects prices in Riga's supermarkets 0 13

Economists from the Bank of Latvia Oleg Krasnoperov and Andrei Bessonov assessed the impact of global prices on inflation in Latvia.

Why are energy prices rising?

On February 28, the United States and Israel struck Iran, which is an important oil exporter. In response, Iran shelled oil and gas processing plants and terminals in neighboring countries (including Saudi Arabia, Qatar, Oman, and the United Arab Emirates), disrupting their operations. Additionally, Iran effectively closed the Strait of Hormuz (through which about one-fifth of the world's oil and liquefied natural gas exports pass), significantly reducing oil production and exports even from those countries in the region whose infrastructure was not damaged.

As a result of these events, global prices for oil and natural gas have risen significantly. Their daily volatility (in response to shelling and statements from politicians) and uncertainty in forecasts have also increased. The transportation of oil and LNG has become more expensive and risky: the number of available vessels has decreased, some have accumulated near the Strait of Hormuz, not continuing their journey, and insurance for vessels has become significantly more expensive.

The costs of oil refining have also risen substantially. The closure of the Strait of Hormuz halted the export of not only crude oil but also petroleum products from Gulf countries. Refineries in other regions (for example, in Asia) were forced to cut production as they could not quickly redirect raw material supplies. As a result, prices for certain petroleum products (such as diesel fuel) in Europe have risen even more than oil prices.

Could it resolve itself?

Markets are often prone to overreacting to current events. For example, in September 2019, an attack on the world's largest oil refinery in Saudi Arabia caused the largest one-time drop in oil production in history and led to a price increase of more than 10% within hours of the stock market opening; however, two weeks later, prices returned to previous levels.

Currently, a scenario of a sharp decrease in tension and a complete restoration of energy transit is not excluded — in this case, prices could even drop below those at the end of February. Nevertheless, significantly increased futures prices indicate that investors consider such an outcome unlikely.

Moreover, this time the markets did not overestimate the events but, on the contrary, underestimated the scale of the conflict (in the early days of March, the price increase was relatively small).

The actual impact of events in Iran on energy prices will depend on:

• the duration and outcome of the military conflict,
• the duration of shipping restrictions through the Strait of Hormuz,
• the extent of production disruptions and damage to processing and export infrastructure,
• the speed of supply replacement from other countries.

External pressure on domestic inflation

Changes in oil prices are most quickly reflected in fuel costs — the main part of the effect manifests within a month. More expensive fuel raises prices for other goods: food, transportation services, restaurants, and tourism.

This time, the impact was particularly rapid — fuel prices in Latvia rose within the first days after the events began, which even raised questions for the Minister of Economy and attracted the attention of the Competition Council. Natural gas plays an important role in Latvia's energy sector. It is used not only for household purposes but also for producing thermal and electrical energy. About half of the heat is produced using gas, especially during the heating season. Gas is also used in cogeneration plants and for balancing the energy system in the Baltic countries.

The transmission of gas price increases to consumer prices differs from oil due to the peculiarities of its storage and supply. Despite the current price increase, the main impact on households may manifest at the beginning of the heating season. Suppliers are already allowing for price increases for the population in the fall.

Two scenarios

To assess the impact of global prices on inflation in Latvia, two scenarios are considered. The first uses current futures prices, which already account for the likelihood of multi-month disruptions. The second is the pessimistic scenario of the European Central Bank, which assumes prolonged restrictions, production disruptions, and higher prices.

Calculations show:

• under the futures price scenario, inflation in Latvia will increase by 1.7 percentage points this year and by 0.9 p.p. next year;
• under the pessimistic scenario — by 3.1 p.p. this year and 2.4 p.p. next year.

However, the impact could be even stronger:

1. A prolonged conflict could further increase energy prices.
2. The cost of food may rise due to the increased prices of fuel and fertilizers.
3. Reduced oil refining decreases the output of by-products (such as sulfur), raising the cost of industrial products.
4. A possible strengthening of the dollar makes imports more expensive for the eurozone.
5. Indirect effects are possible — wage increases and additional inflationary pressure.

The experience of the energy crisis of 2022–2023 showed that such secondary effects can significantly amplify inflation.

It has been worse

At the same time, current energy prices have not yet reached the levels of 2022.

A positive factor is also the increase in LNG production capacity in the United States, which may stabilize supplies to Europe in the coming years.

The initial position of the Latvian economy is also better now:

• the average salary is about 40% higher than four years ago,
• the share of fuel in the consumer basket has decreased,
• energy independence and supply diversification have increased.

Thus, although inflation growth this year is almost inevitable, its scale will also depend on internal factors — income growth, increased energy efficiency, and the development of renewable energy.