Israel-Iran Face-off Triggers Fears Of $100 Oil In Markets

Ever since Hamas launched attacks on Israel on October 7 a year ago, the world's oil markets have been worried about the situation snowballing into a major regional conflict. The biggest concern is that this could lead to a war between Israel and Iran, which is one of the world's top oil producers, ranking seventh in crude production.

Until recently, both Israel and Iran seemed eager to avoid direct conflict. That is why, in spite of the prolonged Gaza conflict and Houthi missile attacks in the Red Sea, initial tremors in the oil markets following the October 7 wildcat strike by Hamas last year soon subsided. As a result, oil prices remained low and stable for most of this year.

But last week, Iran launched about 200 missiles at Israel in retaliation to Israel's attacks on Hezbollah and other groups backed by Iran. Now, the world is watching closely to see how Israel will respond. Oil markets are on edge and, last week, crude prices jumped by 10%, reaching $78 a barrel. This marks the largest weekly increase in nearly two years.

On October 7, oil prices went up again before fluctuating. The last time that a major oil-producing country was involved in war-which happened in Ukraine in 2022-crude oil prices shot past $100 a barrel. Now, people are wondering if something similar could happen again. To get an idea of how much prices could rise, we should first look at the possible ways Israel might respond.

If the attack were limited to military targets, such as missile launch sites, and Iran responded with a moderate approach to calm tensions, the extra pressure driving up oil prices might ease. However, Israel might decide to intensify the conflict by targeting Iran's civilian infrastructure, such as oil and gas facilities or nuclear enrichment sites.

No matter what action Israel takes, Iran might feel compelled to respond strongly, which could lead to a vicious cycle of attacks. This could eventually make Iran's key oil and industrial sectors, which are vital to the regime's survival, targets for strikes. Oil facilities would not have to be hit immediately for global markets to start worrying.

If Israel strikes Iran's oil facilities, it could target sites where Iran converts its crude oil into petroleum products. One option could be the Abadan refinery, which is over 100 years old and supplies 13% of the petrol used in Iran's domestic market. According to data firm Kpler, Iran might manage some of the fuel shortages by smuggling more barrels from Iraqi Kurdistan.

The impact would, possibly, stay within the region and these attacks could actually increase the global supply of crude oil by allowing more of Iran's unrefined oil to be available for export. But, if Israel aims at seriously damaging Iran's energy exports, it could target the oil terminals on Kharg Island in the Persian Gulf, where nine-tenths of Iran's crude oil is shipped, or even strike the oil fields themselves.

That decision could create diplomatic tensions. The Biden Administration would be upset because it could lead to a rise in fuel prices, which is a big concern with the US presidential election just weeks away. China, which buys most of Iran's oil, would also be unhappy. This is important because China manages Haifa, Israel's biggest port, and has made significant investments in Israel's technology industry.

Israel might decide that the risk is worth taking and go ahead with attacking the terminals. A successful strike would immediately remove a significant amount of oil from the global market. Last month, Iran exported 2 million barrels per day, which is almost 2% of the world's oil supply. But, even in that case, the global impact would, possibly, be limited.

Unlike the situation after Russia's invasion of Ukraine, when oil production was at its peak and demand was rising after the pandemic, today, there is plenty of supply and demand is relatively low. Following several production cuts, the Organization of the Petroleum Exporting Countries (OPEC) and its partners, known as OPEC+, have over 5 million barrels per day (bpd) of spare capacity.

This is more than enough to replace any lost oil from Iran. Saudi Arabia and the United Arab Emirates alone have more than 4 million bpd in reserve. They would, possibly, not hesitate to increase production. OPEC+ members, frustrated at losing market share in recent months, have been waiting for an opportunity like this to reverse their production cuts.

Last week, they announced plans to increase production by 180,000 barrels per day each month for a year, beginning in December. The cartel is losing control and such countries as Iraq and Kazakhstan have been exceeding their supply limits for several months. This might prompt other members, especially Saudi Arabia, to speed up their own production increases.

The Saudis seem very determined not to lose any more control over the oil market. Reports suggest they have given up on their goal of pushing oil prices back to $100 per barrel, which is the price they need to balance their budget as they begin several large-scale projects.

Oil production is rising in such countries as America, Canada, Guyana, Brazil and others. The International Energy Agency predicts that non-OPEC countries will increase production by 1.5 million barrels per day next year, which should be more than enough to meet any growth in global demand.

Demand for oil is decreasing due to slow economic growth in the US, China and Europe, along with a shift towards electric vehicles, especially in China. Before the recent rise in tensions in the Middle East, experts predicted that there would be an oversupply of oil by 2025, which would bring prices down to below $70 per barrel.

Reserves of crude oil in rich OECD countries are below their five-year average at present. A strike on Kharg Island would certainly disrupt the markets, but oil prices would, possibly, increase by only about $5 to $10 from the present levels.

However, the situation could become much more unpredictable if Iran were to retaliate against other Gulf countries it views as backing Israel. In recent years, relations between Iran and its neighboring countries have been improving, with Iran officially restoring diplomatic ties with Saudi Arabia in 2023. Recently, Gulf Arab officials met with Iranian leaders in Doha, capital of Qatar, to assure them of their neutral stance. However, with limited choices, Iran might still consider targeting the oil fields of its neighbouring countries, possibly beginning with such smaller Gulf states as Bahrain or Kuwait.

Another way in which Iran could cause global disruption is by shutting down the Strait of Hormuz, a vital route through which 30% of the world's seaborne crude oil and 20% of its liquefied natural gas are transported. Doing so would be like economic hara-kiri for Iran, as it would not only prevent the country from exporting its oil and other goods, but also block many of its essential imports from coming in.

Such a move would also frustrate China, which gets about half of its oil from the Gulf countries. While it is highly unlikely, Iran might still consider this option, especially if strikes or more sanctions on its oil exports significantly reduce its ability to ship crude.

It is difficult to predict how the markets would react to these situations, mainly because any move by Iran would, possibly, lead to responses from Israel, the US and other countries. For instance, the US and China would, probably, send their naval forces to reopen the Strait of Hormuz. However, if the disruptions are severe enough to cause lasting oil shortages, prices would, possibly, rise to a level where demand for oil decreases, eventually leading to a drop in prices.

Experts think that this kind of "demand destruction" would happen when crude oil reaches $130 per barrel, which is about the same level it peaked at in 2022, according to The Economist. If the oil markets thought this scenario was even somewhat possible, their concerns would start showing in the current prices. Traders who had expected prices to drop soon would quickly try to reverse their positions.

Looking at the bigger picture, the recent increase in oil prices does not seem significant, even when compared to the relatively stable levels of the past 18 months. By late-Monday, oil prices rose above $80 a barrel. Last year, the average price was $82 and, in 2022, it was $100. The ongoing conflict in the Middle East, now a year old, has defied many predictions. However, there are many 'ifs' and 'buts' for oil prices to jump to three-digit figures once more.

(The author of this article is a Defence, Aerospace & Political Analyst based in Bengaluru. He is also Director of ADD Engineering Components, India, Pvt. Ltd, a subsidiary of ADD Engineering GmbH, Germany. You can reach him at: [email protected])