Crude Oil Prices at Risk from Middle East Turmoil?
The Israel-Hamas military flare up could imperil global oil markets if fears persist of Saudi Arabia, Iran, and the US being drawn into the fold.
Market Reaction
Crude oil prices surged close to five percent after news broke of a major military flare up between Hamas and Israel. Between October 7th-20th, Brent climbed an additional +5%, bringing crude oil up from $84.37 to $93.16/barrel.
Source: TradingView
Since the peak, crude oil prices have fallen +7% but are still hovering a little over 1.5% higher than where they were on October 6th. What does the price action in crude oil say about how investors view the geopolitical situation in the Middle East?
The data suggestions investors were initially spooked by the military flare up, but those fears subsequently waned - but up to a point. The 1.5% gap between where prices were on October 6th and now suggests a geopolitical risk premium has been baked into Brent.
But this is not without precedent.
A similar but inverted phenomenon happened when former National Security Advisor John Bolton, a notorious Iran hawk was fired, on September 10, 2019. Crude oil prices subsequently fell over 2%.
His departure was interpreted by markets as a reduction in the overall risk of a geopolitically-induced disruption (war) in the global supply of crude oil. Specifically, around the Strait of Hormuz over which Iran has control. We will return to this later.
With the current situation between Israel and Hamas potentially broadening out to involve Iran and Saudi Arabia, a risk premium is now embedded in crude oil. However, after markets digested this risk, Brent is now reverting to its previous downtrend since mid-September and the aforementioned premium may thin out.
But smoldering geopolitical risks could re-invigorate crude oil prices if the situation escalates.
The Geopolitical Side
The conflict has come at a pivotal time in Israeli-Arab relations, which makes the timing of the attack that much more believable as a deliberate derailment operation. Namely, between Saudi Arabia and Israel formally establishing diplomatic relations with the Abraham Accords as the political conduit.
Saudi Arabia not only stewards two of Islam’s holiest sites in the Kindgom’s western Hejaz region, but also exerts significant influence in the Arab world. Joining the Abraham Accords would mark a huge step in Arab-Israeli normalization efforts, a major strategic priority for Washington and Tel Aviv.
In return, the Kingdom would be able to secure a fortified defense pact at a time when relations between Saudi and the US - specifically Biden and MBS - are frayed. The Abraham Accords would therefore satisfy a trilateral set of domestic and foreign policy priorities for the US, Israel, and Saudi Arabia.
However, the flare up between Israel and Hamas and the high number of civilian deaths in Gaza threatens to undermine these efforts. Riyadh may be concerned that in the eyes of the Arab world, continuing to sign the Abraham Accords bilaterally with Israel would amount to khiyaana (betrayal) of Arab solidarity and the Ummah.
The deal is now “on ice”.
Crude Oil Prices at Risk of Geopolitical Escalation?
There are growing concerns that multiple regional players may now be indirectly drawn into the conflict, potentially triggering a long-feared regional war. Iran-backed Houthi rebels in Yemen attempted to fire rockets into Israel before being shot down over the Red Sea by the US Navy.
Iran is known for leveraging proxy groups like the Houthis, Hamas, and Hezbollah to carry out its foreign policy objectives. According to AP News, “U.S. troops also have been targeted in drone attacks on bases in Iraq and Syria claimed by Iranian-allied militia groups since the war started”.
Cross-border attacks between Israel and Hezbollah in Lebanon are now at risk of evolving into direct involvement in the war. According to a Reuters report quoting Mohanad Hage Ali of the Carnegie Middle East Center, “Hezbollah's next steps would be shaped by Israel's plans for a Gaza ground incursion. The prospect of Hamas being dealt a killer blow would propel Hezbollah to intervene”.
Foreign Affairs magazine reached a similar conclusion: “As Israeli forces advance through Gaza, the war could escalate to the point where Iran’s “axis of resistance”—Hezbollah and other Tehran-backed militias in Iraq, Lebanon, Yemen, and elsewhere—become direct combatants”.
Iran does not want to risk open war with the US, Israel - and potentially Saudi Arabia despite their shallow detente - amid its own domestic tribulations. One method short of military warfare will be leveraging geoeconomics: the Strait of Hormuz.
Source: MarketWatch
Iran has threatened to block the Strait of Hormuz before, and remains an economic weapon of last resort, and for good reason. 20-30% of the world’s oil supply flows this critical chokepoint. Sea mines or other blockading measures would have devastating impacts on the global economy.
JPMorgan wrote in a note that asphyxiating this choke point would “supercharge” oil prices at a time when inflation in major economies is finally beginning to settle. One analysis found that the price of oil could rise 50 percent or more within days.
At the current price levels, a 50% increase would mean crude oil trading at under $130/barrel. This would mark the highest level since 2022, and 2008 before that. Some estimates put that figure closer to $150.
However, it is highly unlikely that Iran will choose to leverage this geoeconomic strategy, and is therefore not a major upward risk to crude oil prices at this time. A more likely source of volatility for crude oil prices will come from gradual escalations or sudden developments that elicits a knee-jerk reaction from traders.
One author from the Financial Times drew parallels between the prologue of WWI and now on how a multi-country war could erupt. All major players in modern global politics do not want to go to war - not unlike Europeans in the early 20th-century.
But what dynamics may draw them in is the same: states feeling compelled to do something, because the cost of inaction at an inflection point may be greater. Like a bundle of tightly bound matches, when one is ignited, it is almost impossible to extinguish before others catch fire. Caution will therefore win the day.