Markets Brace for Middle East Oil Supply Shock

The oil market is on edge after tensions between Israel and Iran flared up this week. Fears of an all-out war and an actual disruption to oil supply from the Middle East intensified, pushing oil prices higher.

As the world awaits the Israeli response to the Iranian missile attack on Israel early this week, reports suggest that Israel could target some of Iran’s energy and oil infrastructure.

Unlike in similar geopolitical flare-ups in the recent past, oil prices remained relatively muted for the year after Hamas’s attack on Israel in October 2023, which triggered the current crisis in the Middle East.

That’s because OPEC, which is cutting oil production to “stabilize” the market, is sitting on an estimated 5 million barrels per day (bpd) of spare production capacity.

Analysts believe that OPEC, mostly its Middle Eastern producers Saudi Arabia and the United Arab Emirates (UAE), have enough spare capacity to offset potential losses of supply from fellow member Iran.

However, in case the conflict escalates to Iranian proxies targeting oil infrastructure in Iran’s Middle Eastern neighbors, or if Iran moves to block or restrict oil cargo traffic in the Strait of Hormuz, oil prices could spike to triple digits and record highs, analysts say.

But most watchers and experts see the mother of all oil shocks – a closure of the Strait of Hormuz – the world’s most important chokepoint for oil trade handling about 20 million barrels per day (bpd) – as a low probability event.

Nevertheless, the market is bracing for an actual disruption to supply from the Middle East a year after the current conflict started.

If Iran’s infrastructure is targeted, the maximum damage to the global oil supply would be about 3.5 million bpd, of which around 1 million bpd exports, mostly to China.

Such a disruption is easily within OPEC’s capability to offset, as it has more than 5 million bpd of spare oil production capacity.

“In theory, if we lost all Iranian production – which is not our base case – OPEC+ has enough spare capacity to make up for the shock,” Amrita Sen, co-founder of consultancy Energy Aspects, told Reuters.

Saudi Arabia could increase its oil production by about 3 million bpd and the United Arab Emirates by 1.4 million bpd, analysts say.

The market has started to price in some form of Israeli attack on Iranian oil infrastructure, consultancy FGE said in a Friday note.

Any disruptions to Iranian oil supplies will likely push Brent oil prices above $80 per barrel, but in the absence of that, we could pull back quickly to $70 a barrel, FGE says.

However, in case the conflict escalates, the spare capacity in the Middle Eastern producers could be vulnerable to attacks, according to UBS analyst Giovanni Staunovo.

“The effectively available spare capacity might be much lower if renewed attacks on energy infrastructure on countries in the region happen,” Staunovo told Reuters.

Citigroup sees a possible Israeli attack on Iran’s major oil export facility of Kharg Island, where 90% of Iranian exports originate, as “low probability, high impact.”

But this could trigger Iran to attempt to disrupt traffic in the Strait of Hormuz, which will “represent a tipping point for the global oil market and the world economy,” Citi said in a commentary carried by MarketWatch.

Such an event could lead to a “significant spike well past previous record highs,” the bank’s analysts noted.

Yet, others doubt that the escalation would be that serious.

“[W]ill the US really allow Israel to blow up oil facilities in its antagonist’s border during an election year? Will Iran really close the Strait of Hormuz which will not only cut off neighbours’ exports, but its own, only noteworthy source of international income?” analysts at PMV say.

“Expansion of war and its damage will need to be proven before oil market participants will shake off the over-riding presence of scepticism.”