Oil Bears Are Dangerously Underestimating Geopolitical Risk
For decades, oil prices have been known to fluctuate dramatically, even over distant prospects of war in the Middle East. However, with the advent of U.S. shale, this dynamic has shifted, leading many to assume that anything short of an oil blockade in the Strait of Hormuz will leave oil markets unaffected. But this is a false sense of security. Geopolitics can still significantly impact oil bears, and the recent oil price rally is a testament to this.
The threat of a military escalation between the United States and Iran has prompted a surge in oil prices. Interestingly, the oil blockade imposed by the U.S. on Venezuela earlier this year had little impact on benchmarks. In contrast, a war with Iran has driven Brent crude prices past $67 per barrel and WTI to over $62. This highlights the potential for geopolitical tensions to significantly influence oil markets.
Rystad Energy has published five possible scenarios for U.S.-Iranian relations, with the best-case scenario involving productive talks leading to a new nuclear deal that would increase Iran's oil production. While this is a bearish scenario, the other four scenarios are increasingly bullish, ranging from limited U.S. strikes on Iranian nuclear facilities to wide-ranging strikes, the death of the country's Supreme Leader, and civil unrest following the collapse of the government.
Despite these scenarios, Rystad Energy does not anticipate a significant price increase for crude oil. In the worst-case scenarios, the consultancy expects oil prices to jump by $10 to $15 per barrel due to Iran's production suffering from the aftermath of adverse events. However, some note that if the war spreads across the Middle East, prices could soar above $100.
A Bloomberg article recently explored a scenario where Iran closes the Strait of Hormuz, causing a brief but significant price shock. Historical data suggests that such a disruption would affect 20% of global oil supply, potentially leading to an 80% price jump. However, the effect on oil prices from this worst-case scenario would be limited, as the world's energy needs have decreased over time.
The reason for this is energy efficiency, with the authors noting that "In the U.S., the amount of oil needed to produce one unit of GDP has fallen by about a quarter since 2011." However, on a global scale, crude oil remains the top primary energy source, meaning a price shock would still cause pain, albeit not as much as it might have in the past, thanks to inflation. "Inflation means $100 oil today buys fewer goods and services than $100 oil a decade or two ago," wrote Dina Esfandiary and Ziad Daoud.
Despite the potential for escalation, the U.S.-Iranian conflict is unlikely to result in a major disruption. Reuters reported this weekend that Iran is open to a deal with the U.S., suggesting the Iranian side is willing to make concessions to strike a deal and lift sanctions. This would be highly bearish for oil prices, as it would likely lead to an expansion in Iran's oil production.
However, if the two parties fail to agree on a deal, the potential for escalation remains. The prospect of a deal is also distant, despite this latest signal from Tehran. Last week, oil prices rose on reports that the U.S. was building a substantial military presence in the Persian Gulf, signaling its readiness for an extended conflict with Iran. This extended conflict significantly raises the risk of oil infrastructure being targeted and disrupting Iran's production, currently at around 3.2 million barrels daily.
The extended conflict scenario also increases the risk of other Middle Eastern oil producers being drawn into the fighting as targets for strikes, facing potential disruption to their oil infrastructure. Yet events from last year suggest that no one in the Middle East really wants oil prices to skyrocket. While oil demand is among the least elastic in the world, it still responds to price shocks.
Some analysts point to China's oil storage spree as evidence that there will be no oil price shock. China is the world's largest importer of crude, the biggest buyer of Iranian crude, and has been buying more oil than it refines for over a year, building new storage to keep doing so. However, the rest of the world does not have China's capacity to insulate itself against such price shocks. For the rest of the world, and for China, too, a geopolitical price shock would be painful.
