FOLLOWING THE assassination of Iranian al-Quds commander Qassem Suleimani and Iran’s retaliation against two Iraqi bases containing US troops, there was an initial sharp reaction. Oil prices spiked by 10 per cent, US and global equities dropped by some percentage points and safe-haven bond yields fell. But the view that both sides would back down, and the US’s newfound oil strength calmed investors and reversed these price movements, with equities even approaching new highs.
While oil prices did surge after the killing of Suleimani last week, a 10 per cent rise is tiny compared with the swings seen in past years. Over the last 10 years, fracking has allowed the US to squeeze the oil and gas from shale and transform the country into the largest producer of both. According to Stewart Glickman, energy analyst at CFRA Research, “if we had the same skirmishing between the US and Iran happening 20 years ago or even 10 years ago, I think the impact on the oil markets would have been a lot bigger, because the shale revolution hadn’t happened yet.”
Oil prices are not being driven higher, but probably should. The assassination of Suleimani happened on Iraqi soil, without Iraqi permission, while Suleimani was on official business. Surely you would expect some sort of change to the oil supply?
But, the global oil market now has an abundant supply, fed by soaring US production. America has been transformed from a huge importer to a new exporter in under a decade; exports grew from 0.6 million barrels per day in early 2017, to over four million by December 2019. For several years, OPEC and Russia have cut their own production to keep prices from falling, due to US supply. There is seemingly a perception that the oil market can absorb any shock, even the loss of life in a military exchange.
There is clearly confidence in the markets that shipping lanes will be unaffected. Oil flows have not been disrupted so far, and there is no sign that Iran will seek to hobble trade in the fuel industry by closing the Strait of Hormuz, the busiest and most important waterway for the world’s oil industry.
According to Bjonar Tomhaugen, head of oil market research at Rystad Energy, the markets are “pricing in just a low probability of something happening”. Further, markets have got so used to a surplus of oil in the global market that they are not as worried about tensions in the Persian Gulf region as they once were.
The view that both sides would refrain from further escalation calmed investors and reversed the initial oil price shock, with equities even approaching new highs. But the markets are banking on the fact that neither the US or Iran want a full scale war, as this would threaten the Iranian regime and Donald Trump’s re-election prospects. Investors also seem to believe that the economic impact of a conflict would be modest.
This is because oil’s importance as an input in production has fallen sharply since past oil-shock episodes, for example the 1973 Yom Kippur War, Iran’s 1979 Islamic Revolution and Iraq’s 1990 invasion of Kuwait. Additionally, because the US is now a major energy producer, inflation expectations are much lower than in past decades; there is little risk of central banks raising interest rates following an oil price shock.
The assumption that conflict between the US and Iran will not greatly affect oil prices, however, is flawed. The risk of a full-scale war may seem low, but there is reason to believe that US-Iranian relations will not return to the status quo and the idea that a zero-casualty strike on two Iraqi bases has satisfied Iran’s need to retaliate is simply naïve. This conflict will continue to feature aggression by regional proxies, direct military confrontations, and efforts to sabotage Saudi and other gulf oil facilities.
Further, the assumption about what a conflict means for markets is equally mistaken. The US is less dependent on foreign oil than in the past, but even a modest price spike could trigger a broader downturn or recession, as happened in 1990. So while an oil-price shock would boost US energy producers’ profits, the benefits would be outweighed by the costs to US oil consumers.
According to an estimate by JP Morgan, a conflict that blocks the Strait of Hormuz for six months could drive up oil prices by 126 per cent, to more than $150 (£115) per barrel, setting the stage for a global recession. Even a modest oil-price increase to $80 per barrel would lead to a sustained risk-off episode, with US and global equities falling by at least 10 per cent, in turn, hurting investor, business and consumer confidence.
Despite Wall Street’s optimism, even a mild resumption of US-Iran tensions could push global growth below the mediocre level of 2019. An alternative perspective suggests that concerns about growing restrictions on the use of fossil fuels because of their role in climate change have also weighed on prices, as “people don’t want to be invested in oil” said Gary Ross, chief executive of Black Gold Investors.
According to the chairman of JBC Energy, Johannes Benigni, if the current government of Iran is toppled, crude oil prices could drop to $40 a barrel. A regime change could return Iran to the negotiating table, implying that the US administration could be happy enough with that to lift the sanctions - an act that would no doubt flood the market with Iranian oil.
The likelihood of a regime topple is unclear. Protests erupted in Iran last week after the government admitted the army had struck a Ukrainian plane by mistake. Should this happen, the new rulers of Iran might be better disposed towards Washington and agree to negotiate with the Trump administration. This demonstrates, yet again, the instability of oil markets in their relation to political changes.