Ever since the escalation of hostilities between Hamas and Israel on October 7, many have been wondering whether the much touted geopolitical risk premium will fire up crude oil prices.
Tepid global demand in an uncertain macroeconomic climate and plenty of non-OPEC, more specifically non-Middle Eastern, oil barrels on the market have ensured such a premium has not quite reared its head yet.
The U.S. leading global crude oil production into 2024, and an upswing in production from the likes of Brazil, Canada, Norway and the new crude kid on the block Guyana, have kept the market honest.
So much so, that even attacks by Yemen’s Iran-backed Houthi rebels on energy and commercial shipping in the Red Sea since November, and U.S.-U.K. retaliatory attacks have failed to meaningfully move oil prices higher.
But the events of Sunday (January 28, 2024) carry the potential ratcheting up the risk premium, as three U.S. service members were killed and 34 injured in an unmanned aerial drone attack on forces stationed in a northeast Jordan outpost near the Syria border. They are considered to be the first U.S. fatalities from hostile attacks since the Israel-Hamas conflict began.
Responding to the attacks, U.S. President Joe Biden said: “While we are still gathering the facts of this attack, we know it was carried out by radical Iran-backed militant groups operating in Syria and Iraq.
“Have no doubt — we will hold all those responsible to account at a time and in a manner our choosing.”
His words couldn’t possibly have been any less stronger. With Biden’s policy of deterrence since October 7 – aimed at preventing an escalation of tensions across the Middle East – having largely failed, and an election cycle in full swing at home, a U.S. response is coming.
A black swan event for oil markets?
Traders are trying to figure out where this latest escalation is heading. After an intraday spike, oil futures shrugged off the initial shock. At 10:35 am EST on Monday (January 29, 2024), the Brent front month futures contract was seen giving up all of its gains and trading at $81.89 per barrel down $1.06 or 1.28%.
It was a similar story with the West Texas Intermediate (WTI) down $1.22 or 1.56% to $76.79 as the market awaits what’s next. For starters, a U.S. response is near guaranteed to be a strong one as Biden cannot afford to look weak.
Even the Iranians know that. Iran’s currency – the rial – hit an 11-month low in free markets against the dollar. It shed a further 6% on Monday and is now down by nearly 20% since October.
Unsurprisingly, realizing the seriousness of the situation, Iran’s foreign ministry has said the attack on U.S. troops has nothing to do with it, and any regional militias claiming responsibility for the attack do not receive their orders from Tehran.
So what follows next? Hitting targets on Iranian soil is one escalation that will likely send oil markets into a tizz. U.S. hawks are demanding action. However, an American attack on Iranian soil hasn’t happened since the 1980s. Should it happen, then all conventional bets are off, and oil prices could likely spike by 5% over the near-term.
The price spike could be higher in the event of a prolonged escalation. The development not only has the potential for Iran’s production facilities to be hit but also that of wider blockages in the Strait of Hormuz, a key maritime artery for crude supplies.
Saudi Arabia, Kuwait, Iraq, Iran and to an extent United Arab Emirates’ crude, as well as Qatar’s Liquefied Natural Gas (LNG) cargoes pass through the Strait daily. Additionally, Iranian crude exports – were they to be knocked offline – have accounted for 2.5% to 3.1% of the global market in recent years.
All signs are that neither Tehran nor Washington wants this. The Biden administration could, and most likely will, opt for broad-ranging military strikes on Iran-backed militias peppered around the Middle East from Syria to Yemen.
And / or there could be limited strikes on specific targets in Syria, Lebanon, Yemen and Iraq. However, the efficacy of these beyond symbolism is doubtful. Both will most likely not end matters and skirmishes would continue threatening a further escalation down the line.
Stability of Abraham Accords in peril
That leaves geopolitical risk level elevated with no obvious end in sight but will not materially alter near-term oil pricing quite like a direct U.S. attack on Iran would.
But Potential prolonged regional skirmishes could indeed upend progress made under the Abraham Accords initiated by the U.S. during Donald Trump’s presidency aimed at normalizing relations between Israel and the wider Middle East.
The Accords have thus far led to Bahrain and United Arab Emirates establishing diplomatic ties and trade links with Israel, while progress had been made to normalize relations with Saudi Arabia as well.
Many believe Hamas’ attack to be a targeted disruption of progress made by the Saudis, Israelis and other regional powers. Iran likely loathes such normalization of international relations in the region as well, as do many of its proxy militias such as Lebanon’s Hezbollah.
Still a story of crude demand too
Regardless of supply-side scenarios, oil demand downsides persist. As the International Energy Agency (IEA) notes: “The (market) slowdown is set to continue in 2024 as GDP growth stays below trend in major economies. Efficiency improvements and a booming electric vehicle fleet will also drag on demand.”
As such, it sees global demand growth for 2024 in the region of 1.1 million bpd while OPEC puts its projection at 2.25 million bpd. But market projections point to non-OPEC output uptick servicing even the higher end of demand growth for 2024 on its own, regardless of what oil producers group OPEC+ led by Russia and Saudi Arabia does or doesn’t.
Such a supply/demand market dynamic – prior to the latest escalation – appeared unlikely to provide a price supportive environment early in 2024. It did look like oil prices would be stuck in the current price range of $70 to $85 per barrel for 2024, using Brent as a benchmark.
However, depending on whether the U.S. ups the ante by directly attacking Iranian soil, or comes up with a hard response by other means, may well see the oil price average around $85 per barrel in 2024. Furthermore, the upper end of crude price estimates may well get hiked as high as $90-95 over the near-term.