Storm clouds, silver linings

Storm clouds are building over the Middle East as the long-feared escalation of the conflict there arrived in recent days. The latest round of a decades-old conflict started a year ago with Hamas’ October 7 attack in the south of Israel.

Israeli armed forces responded by bombing and invading Gaza and, in the past few days, turned its attention to Iran-backed Hezbollah to the north in Lebanon, killing several of its top leaders. Iran’s response was to rain almost 200 ballistic missiles down on sites in Israel, though damage was limited.

The next stage of the conflict is not yet known. There is likely to be an Israeli counterstrike, backed by the US, but will it be a largely symbolic affair as earlier in the year, or will it be a genuine attempt to destroy Iranian military or industrial capacity? How does Iran respond then? With its economy already under severe pressure, can it afford a further escalation?

This is a volatile situation that has implications far and wide, including the US election that takes place in a month’s time. However, the sad reality is that, despite the tens of thousands of people, mostly Palestinian civilians, who have already been killed in the past year, the main reason investors care more about this conflict than others, such as wars in Sudan or Myanmar, is because of oil. The region’s bond and equity markets are insignificant in the global context, but it remains the source of about a quarter of the world’s oil. Iran is a major oil producer in its own right, and if Israel attacks Iranian facilities, its output could be reduced. However, Iran can also disrupt the global oil market by impairing maritime traffic in the Strait of Hormuz, a vital chokepoint through which most Middle Eastern oil is transported.

Spike
Unsurprisingly, oil prices spiked over the past week, reflecting the increased concerns of supply disruptions. However, at $78 per barrel, the price of Brent crude is well within the broad trading range of the past three years.

Before the missile strikes, the oil outlook was rather bearish, with reports that Saudi Arabia was considering abandoning the OPEC production cuts it agreed on and focusing on gaining market share rather than maintaining a target price. This would basically mean starting a price war and could send prices even lower.

Chart 1: Brent crude oil, dollars per barrel

Source: LSEG Datastream

OPEC and Russia (known as OPEC+) implemented a series of production cuts since 2022 amounting to around 5 million barrels per day, or 5% of global demand, in order to support prices. Unwinding this could theoretically replace Iran’s total output of 3 million barrels per day if the cartel feared that oil markets would become destabilised, but the price jumps would need to be significant. It also means, however, that the oil price has largely been propped up by voluntary production limits. In a truly free market, oil prices would be lower by now.

Prices would also generally be more volatile, since at lower prices some producers would go out of business, eventually leading to higher prices. In that sense, OPEC has played an important role in stabilising global oil prices, but of course it has largely aimed to do so at levels that suit its members, not consumers.

It is becoming increasingly difficult to play this stabilising role since OPEC’s share of global output has declined from around 55% in the 1970s to 30% today. Some countries have left the cartel, while other non-members have emerged as new major producers, notably Brazil and Guyana. Importantly, the US is the world’s largest oil producer these days thanks to fracking, reducing OPEC’s grip on oil markets. It also means the US economy is even less exposed to oil price volatility today than it was in the past.

Not the 70s show
In other words, while oil prices could still move even higher, it seems unlikely that prices would spike back to $130 as was the case in the wake of the Russian invasion of Ukraine. Certainly, a repeat of the 1970s oil shocks, sparked by the Yom Kippur War in 1973 and the Iranian Revolution in 1979, is highly doubtful. Oil prices rose tenfold in real terms between 1970 and 1980, devastating a global economy that was much more dependent on oil than is the case today, and contributing to persistently elevated inflation. As chart 2 shows, the inflation-adjusted price of oil today is in line with its long-term average and therefore does not pose much of a risk at current levels. The 1990 spike following Iraq’s invasion of neighbouring Kuwait and subsequent war with the US is clearly visible, as is the 2022 increase in the wake of the Russian invasion of Ukraine. In contrast, last year’s October 7 attack and Israel’s various retaliations barely show up.

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