Why the oil market didn't believe in a major war in the Middle East

On the night of June 22, the United States struck three nuclear sites in Iran. As wrote The Wall Street Journal, through Arab countries, Washington informed Tehran that the attack was a one-off and that it was now possible to return to negotiations on the nuclear deal. However, whether this message had the effect the White House hoped for is still unclear: Iranian Foreign Minister Abbas Araqchi excluded a diplomatic way to resolve the issue after the US strikes. Trump himself urged Iran to go for a peaceful solution to the issue, otherwise threatened  «larger» attacks. 

Oil traders are now preparing for a spike in oil prices when trading opens on Monday. All their attention is focused on exactly how Tehran will respond to the U.S. strike and whether Tehran's response to the U.S. airstrikes will disrupt oil supplies, which have been largely unchanged so far, wrote Bloomberg.

After the U.S. directly intervened in the Iran-Israel conflict, «the question is not whether the oil price will react, but how much and how fast», SEB analyst Ole Hvalby told the WSJ;

Brent closed at around $77 per barrel on Friday. SEB expects the price of Brent crude to rise $3 to $5 when markets open. But it could reach $100 if Iran follows through on earlier threats, Saul Kavonik, an energy analyst at MST Marquee, told Bloomberg: «A U.S. attack could lead to a broader conflict, including Iranian retaliation, such as strikes on oil infrastructure in countries like Iraq or attempts to impede ship passage through the Strait of Hormuz.»

«Any blockage of the strait will lead to a significant increase in oil prices,» adds Hvalby.

So far, full-scale military actions in the Middle East, strangely enough, have not provoked panic in the oil market. Volatility has indeed jumped, but there has been neither a rise in quotations by tens of percent nor triple-digit prices;

Last Friday, June 13, when Israel began striking Iran, the price of Brent crude oil soared by 13%. Such a sharp jump was largely due to the mass closing of short positions (bets on the downside, to get out of which traders had to buy oil contracts);

After an initial rise to $78.5 per barrel, quotations retreated and this week reached only $79.04 (on Thursday), despite the continued escalation. Israel bombed Iranian facilities related to its nuclear program, and the latter responded by launching several hundred rockets at Israel;

Meanwhile, every hint of defusing tensions was immediately met by a market pullback, most recently on Thursday evening when Trump announced that he would make a decision on a possible strike on Iran «within two weeks» as there was a «significant chance of negotiations.»[ 

As a result, volatility during the week was around $8. 

And while the options market has seen the bulls predominate over the bears even more so than after Russia's invasion of Ukraine (and for all the time since 2013 that such data has been collected), the traditional futures market has not seen anything like the events of February-March 2022. While there was no risk of oil facilities being damaged or supply disruption then, the price of Brent soared more than $40 in a week and a half, surpassing $139 per barrel at its peak.

«At least for the moment, the market remains very well supported in that super-volatile $70-80 a barrel range,» said Robert Rennie, director of commodities markets at Westpac Banking Corp. about the situation.

However, the scale of hostilities, the risks of strikes on oil facilities and Iran's attempts to cut off supplies to the global market have already forced analysts to revise their forecasts;

Morgan Stanley in early May lowered its estimate of the average Brent price in the second half of the year from $62.5 to $57.5 per barrel. But this week raised it for the third quarter by $10 to $67.5, assuming the conflict doesn't affect oil supplies. However, that's still about $10 below the current price.

Barclays warned that prices could rise to $85 a barrel if Iranian exports are cut in half, and to about $100 in a «worst-case» scenario of the conflict escalating. 

Citigroup economists warned that a significant increase in oil prices «would be a negative shock to the global economy, lowering growth rates and raising inflation, which would create additional problems for central banks». Such developments, though, traditionally lead to a drop in demand for oil and a consequent decline in oil prices over the longer term, notes Jon Treacy, publisher of investment newsletter FullerTreacy Money.

The attention of traders, analysts and investors is now focused on the Strait of Hormuz, which Iran virtually controls and may try to block tanker traffic through it. And they export 18-19 million barrels of oil through it every day, almost a fifth of the world's consumption;

«Saudi Arabia, Kuwait, Iraq and Iran are completely locked into one tiny export passageway,» described the supply situation across the Strait of Hormuz by analysts at Rabobank.

Iran's economy depends heavily on the free passage of goods and ships through this route, and all of its oil exports go by sea, JP Morgan analysts note: «Closing the Strait of Hormuz would be counterproductive to Iran's relationship with its only oil buyer, China.»

Independent Chinese refineries buy more than 90 percent of Iranian crude, which is sold at a discount and mostly delivered by shadow fleet tankers. China's own oil reserves have reached a record 1.18 billion barrels, which will allow it to do without Iranian crude for some time.

It is true that if regime change in Iran becomes the main objective of the war Israel is waging, maintaining a stable oil supply is unlikely to remain a priority for the Iranian leadership, warned analysts at RBC Capital Markets.

With the Strait of Hormuz blocked, Iran is unlikely to be able to continue supplying China, so such action would be an act of desperation, adds Treacy.  

After the escalation of the conflict between Israel and Iran, market participants did not forget that it is now well secured and able to compensate for the loss of at least Iranian exports. This is largely why oil prices have so far, although jumped due to traders' nervous reactions to politicians' statements and developments, but have not rushed upwards;

Iran now produces about 3.3 million bpd and exports 1.7 million, according to analysts at ING. Meanwhile, spare capacity in Saudi Arabia and the UAE, which are easily brought online in those countries, exceeds 4 million bpd, noted The Wall Street Journal. During previous supply shocks, the two oil producers replaced 80% of lost barrels within six months, according to a Goldman Sachs analysis. 

At the same time, OPEC+ countries, under pressure from Saudi Arabia, have already announced three times larger-than-planned supply increases (in May, June and July), which together will increase production by 1.37 million barrels per day. Warren Patterson, director of commodities strategy at ING, expected even before the Israeli-Iranian war that OPEC+ would not stop there and would return the full 2.2 million barrels to the market by the end of the third quarter, 12 months earlier than expected;

In the last report, ING analysts noted that in case of any supply disruptions, OPEC could increase production even faster, especially since the cartel has 5 million bpd of spare capacity to do so;

The current jump in quotations has also given an unexpected respite to shale producers in the United States, who had already started to reduce drilling volumes due to the price drop below $70 per barrel in spring;

Unless the crisis disrupts exports, «the oil market looks well supplied in 2025» as demand cools and OPEC+ countries ramp up production, the International Energy Agency said in its monthly report. A good indication of the growing surplus was commercial oil inventories, which rose by an average of 30 million barrels each month from February through April and added an estimated 93 million barrels in May;

According to the IEA's medium-term forecast to 2030, Chinese demand, which increased by 6 million bpd over the previous decade, accounting for 60% of global growth, will peak in 2027. China's state-owned CNPC expects that to happen as early as this year. According to IEA analysis, by the end of the decade, the spread of electric vehicles will «kill» 5.4 million barrels of global demand per day.

Meanwhile, production in Brazil, Canada and Guyana will continue to grow;

In recent years, the oil market as a whole has been on a steady downtrend, indicated by five price peaks one below the other, starting at $97 per barrel in September 2023. Now, «as the price approaches $80, the sustainability of this trend is increasingly in question,» and there is a possibility of it breaking as a result of a price spike due to geopolitical events, Treacy pointed out;