The oil market is on tenterhooks as the conflict in the Middle East escalates, with much hinging on Israel’s next move in response to Iran’s recent missile attack. While oil prices have risen, the market remains surprisingly calm, despite the looming threat of supply disruptions.
While some analysts are puzzled by this modest price premium, particularly given the high stakes surrounding the Strait of Hormuz—a critical chokepoint for global oil flows—others take comfort in recent hikes in output from Saudi Arabia and Libya and the potential of shale oil production in the United States.
“Geopolitical tensions only become an influence on the market when something happens to energy prices.”
Joost van Leenders, Van Lanschot Kempen
Slow economic growth in China, the world’s biggest oil importer, also keeps a lid on the market. “From the demand side, you see little upward pressure on the oil price. That is not only the case in China but also in the energy-intensive industry in the West,” said Joost van Leenders, senior investment strategist at Van Lanschot Kempen. “Geopolitical tensions only become an influence on the market when something happens to energy prices.”
The market is awaiting what Israel targets in its potential retaliation. If Israeli strikes hit key Iranian oil infrastructure, including production sites or ports, it could trigger significant supply disruptions. Yet for now, prices have only inched up, suggesting the market is underestimating the risk of a larger-scale conflict that could send oil prices skyrocketing to unprecedented levels.
The market, analysts said, is perfectly capable of absorbing a possible production loss in Iran, which produces about 3.2 million barrels a day. Saudi Arabia still has around two million barrels per day of spare capacity, and Libya has recently increased its production again to above one million barrels per day.
Strait of Hormuz
The main worry, although still a worst-case scenario, is that these disruptions could extend to the Strait of Hormuz, impacting oil shipments from the Persian Gulf. ‘Almost a third of global seaborne oil trade moves through the Strait of Hormuz and while some pipeline infrastructure means that a portion of oil flows could be diverted to avoid the Strait, it still leaves in the region of 14m b/d of oil supply at risk’, said Warren Patterson, ING’s head of commodities strategy, in a note to investors. ‘A significant disruption to these flows would be enough to push oil prices to new record highs, surpassing the record high of close to $150/bbl in 2008’.
Such an increase, if it were to last, would also have major ramifications for global inflation scenarios. It could disrupt growth projections for major economies.
A geopolitical risk ignored?
Despite the rising tension, oil prices have been surprisingly restrained. North Sea Brent blend crude has risen just 7 percent since the October 1 attack, barely touching 80 dollars a barrel. While this marks a two-month high, analysts warn that it could be the calm before the storm. Several have predicted that prices could surge past 100 or even 150 dollars per barrel if hostilities disrupt the massive flows of oil through the Strait of Hormuz.
According to S&P Global Commodity Insights, the risks of a supply shock are real. ‘The escalation of the Middle East conflict into a large-scale military operation, potentially affecting energy assets upstream or midstream, poses a substantial upside risk to prices’, they noted in a report last week. The possibility of strikes targeting Iranian oil production, refineries, or shipping routes could severely curtail exports and send ripples across global markets.
Yet, as Louis Gave of Gavekal Research points out, the market seems oddly detached from these dangers. ‘The energy market is behaving in a way that doesn’t reflect these geopolitical risks’, Gave said, highlighting the fact that other commodities like copper and iron ore have bounced back, while energy continues to lag behind. This disconnection could be due to the belief that Saudi Arabia and the U.S. shale industry can ramp up production quickly enough to cover any lost supply from Iran.
Saudi Arabia’s role
Saudi Arabia, with its two million barrels per day of spare capacity, could indeed provide a buffer if Iranian supplies are disrupted. Opec+ has also signalled its readiness to unwind voluntary production cuts to stabilise the market. However, drawing on this spare capacity would exhaust the market’s safety net, leaving little room to manoeuvre in the event of further disruptions. “If we exhaust that spare capacity, we are entering a market with no safety net,” Gave warned, noting that even minor disruptions could lead to ‘explosive growth’ in oil prices.
Saudi Arabia’s breakeven oil price is estimated to be above 90 dollars per barrel, giving Riyadh little incentive to flood the market and suppress prices unless they soar significantly higher. “Saudi Arabia is in no rush to bring prices down. Their break-even price means they would be happy with oil hovering at or above 100 dollars per barrel,” ING’s Patterson said.
Potential inflationary shock
The impact of such a price surge would be felt far beyond the oil market. Higher energy prices would drive up inflation, exacerbating already high price pressures in major economies. This is particularly concerning for central banks, which have been battling persistent inflation with aggressive interest rate hikes. S&P Global warned that any significant disruption in oil flows through the Persian Gulf would not only push up crude prices but also lead to volatility in refined products like diesel. This could have serious implications for Europe, which has become more dependent on Middle Eastern refined products following sanctions on Russian oil.
Higher energy costs would ripple through the global economy, pushing up prices for everything from transportation to food. “This is a stagflationary scenario,” said Gave, warning that rising energy prices could choke off both consumer demand and business investment, leaving central banks with little choice but to raise rates even further. The result: slower growth and higher inflation—an economic double whammy.
Potential global food crisis
A disruption of the Straits of Hormuz ‘would lead to a worldwide supply-gap psychosis, which would be reflected in a wild rise in the cost of freight and agricultural fertilisers’, said ING in its note. “This, together with unusual droughts and floods in the traditional world barns and the consequent application of restrictions on the export of commodities from these countries to ensure their self-sufficiency, could lead to shortages of agricultural products on world markets, the rise of their prices to stratospheric levels and the consequent global food crisis.”
In the event of a significant supply disruption, governments around the world would likely tap into their strategic petroleum reserves (SPR) to cushion the blow. However, these reserves are finite. The U.S. SPR, for example, has been significantly depleted over the past year, leaving just over 380 million barrels, the lowest since 1983 and well below the 600-700 million barrels seen in recent decades.
ING warned that while the SPR could provide temporary relief, it “won’t be enough to offset a prolonged supply disruption.”
“The importance the of strategic reserve is of course a lot less than 20, 30 years ago, though. After all, the US has become a net oil exporter,” says Leenders. “So we have to see this more of a global perspective.”
With daily consumption of between 20 million barrels, US reserves currently cover less than three weeks. China’s strategic reserves, at some 511 million barrels, can cover 40 to 50 days. In Europe, strategic oil reserves however appear relatively high, with all EU member states required to keep at least 90 days of supplies in storage.
ARA oil tanks well stocked
According to the Amsterdam-Rotterdam-Antwerp (ARA) area storage dashboard by Cova, the Dutch government’s oil storage authority, oil product supplies topped 6000 kilotons at the end of September, the highest since May last year. Cova is legally required to maintain a minimum of 90 days of consumption. Diesel storage amounted to 138 days in September.
Cova data also shows that Europe has become more dependent on Saudi Arabia for oil product imports following sanctions imposed on Russia. These imports could still reach Rotterdam from Saudi’s refineries on the Red Sea and would not necessarily be disrupted by a blockade of the Straits of Hormuz.