10/12 – International News & Economics Story

Since Hamas’s attack on Israel a year ago, the oil market’s primary concern has been the potential escalation into a regional conflict involving Israel and Iran, the world’s seventh-largest oil producer. 

Previously, both nations appeared eager to avoid such a scenario even amidst  rising tensions. This is why, despite the war in Gaza and missile attacks by the Houthis in the Red Sea, initial fears in oil markets after the events of October 7th last year were short-lived, and oil prices remained relatively low and stable throughout most of the year.

However, last week, Iran launched around 200 missiles at Israel in retaliation for Israel’s strikes on Hezbollah and other Iranian-backed proxy groups. The world now waits anxiously for Israel’s response, with oil markets showing signs of unease. 

Crude prices surged by 10% last week, reaching $78 a barrel, marking the largest weekly increase in nearly two years. On October 7th, they spiked again before becoming volatile. The last time a major petrostate was involved in conflict, during Russia’s 2022 invasion of Ukraine, oil prices exceeded $100 a barrel. [The Economist]

If Israel retaliates by only targeting military assets, and Iran responds cautiously to ease tensions, some of the geopolitical pressure lifting oil prices might dissipate. However, if Israel escalates by choosing to strike Iran’s civilian infrastructure or oil facilities, Iran may feel compelled to retaliate strongly, potentially turning its oil industry—vital to the regime—into a target. In this case, even if oil assets are not directly attacked, global markets would still be nervous.

An attack on Iran’s oil facilities might focus on key assets such as the Abadan refinery, which supplies 13% of the country’s petrol. [The Economist]

If Israel seeks to disrupt Iran’s oil exports, it could target Kharg Island, which handles 90% of Iran’s crude shipments, or even go after oil fields. However, such moves would carry diplomatic repercussions, especially with the U.S. and China. The Biden administration would be displeased, particularly with the potential for rising gas prices just before the U.S. presidential election. China, which receives most of Iran’s oil, would also be upset. 

Despite these risks, Israel might still see the benefit in striking Kharg Island, potentially taking a significant portion of oil off the global market. Iran recently exported a record 2 million barrels per day, equivalent to nearly 2% of global supply. [The Economist]

Even then, global impacts might be limited. Unlike the situation following Russia’s invasion of Ukraine, oil supply today is relatively abundant while demand remains weak. OPEC+ has more than 5 million barrels per day of spare capacity, more than enough to offset any disruptions to Iranian oil. Saudi Arabia and the UAE alone hold more than 4 million barrels per day in reserve and are likely to increase production quickly if needed. 

OPEC+ members have been eager to reverse their production cuts, with plans to boost output by 180,000 barrels per day starting in December. The group’s internal discipline is already weakening, with Iraq and Kazakhstan exceeding their supply limits for months, which could prompt other members, including Saudi Arabia, to ramp up production even more swiftly. [The Economist]

Non-OPEC production is also increasing in countries like the U.S., Canada, Brazil, and Guyana. The International Energy Agency projects that non-OPEC output will grow by 1.5 million barrels per day next year, which should cover any increase in global demand. Moreover, sluggish economic growth in the U.S., China, and Europe, coupled with the shift to electric vehicles, especially in China, has slowed demand for oil. 

Before the latest escalation in the Middle East, analysts were predicting an oil surplus by 2025, with prices possibly dropping below $70 a barrel. Currently, crude inventories in OECD countries are below their five-year average, so while a strike on Kharg Island could briefly jolt markets, prices would likely stabilize at only $5-10 higher than current levels. [The Economist]

However, things could become more volatile if Iran retaliates against other Gulf states that it sees as backing Israel. Although Iran’s relations with its neighbors have been improving, as diplomatic ties with Saudi Arabia were restored in 2023, there’s still a chance that Iran could target oil facilities in smaller Gulf states like Bahrain or Kuwait.

Another possibility is Iran closing the Strait of Hormuz, through which 30% of the world’s seaborne crude and 20% of its liquefied natural gas pass. This move, though unlikely due to the economic consequences for Iran itself, would have devastating effects on global oil markets and would anger China, a major importer of Gulf oil. Even so, should Iran’s oil exports be severely constrained by strikes or sanctions, it’s not entirely inconceivable.

Predicting how markets might react to such events is challenging because Iran’s actions would likely trigger further responses from Israel, the U.S., and other actors. If disruptions were severe enough to cause lasting shortages, oil prices could rise to levels that reduce demand. Analysts estimate that this “demand destruction” would occur if prices hit $130 a barrel—the level seen in 2022. Should oil markets start considering such a scenario likely, those fears would begin to be reflected in current prices. 

Yet, in retrospect, the recent price increases do not appear extreme. On Monday, prices edged past $80 a barrel, not far from last year’s average of $82 or 2022’s $100. Although the ongoing conflict in the Middle East has defied many expectations, oil prices returning to triple digits would require multiple factors to go very wrong.