Oil markets weigh prospect of a full-scale Iran-Israel war

Despite sanctions, Iran is still a big oil producer, with huge refining capacity. It also controls waterways crucial to the flow of Gulf oil. Yet the West has reserves and China’s demand is dropping.

AFP

Representatives of OPEC member states hold a press conference following the their meeting in Vienna, Austria.

Oil markets weigh prospect of a full-scale Iran-Israel war

Abdulfattah Khattab

last update on 12 Nov 2024

Since Iran and Israel began trading military blows directly earlier this year, analysts have been trying to understand what impact any war between these two regional foes would have on oil prices and supply.

So far, Israeli air strikes against Iranian sites have only hit military facilities, not Iran's nuclear or oil infrastructure, but were Israel to change its targeting, it could bomb oil storage facilities, refineries, or both. This—plus Iran’s response—would have big repercussions for the entire region.

Markets are jittery in part because Iran could respond by closing critical waterways like the Strait of Hormuz and Bab al-Mandab. More than 20 million barrels of oil pass through the Iran-controlled Strait of Hormuz every day, which is around 30% of the global oil trade. Iran’s Yemeni ally—the Houthi militia—likewise controls access to the Red Sea.

EPA — A Houthi walks across the beach with a cargo ship seized by the Houthis in the background, on 5 December 2023

Iran has one of the most extensive refining capacities in the Middle East, with a production capacity of around 2.4m bpd, distributed across ten main sites. The top three refineries are based at Esfahan, Abadan, and Bandar Abbas. Could they be in Israel's crosshairs?

Drawing a line

Last month, on 4 October, Israeli newspaper Yedioth Ahronoth reported that Israel was mulling a strike on Iranian oil facilities. US President Joe Biden was quick to urge Tel Aviv not to do so. “If I were in their shoes, I’d be thinking about other alternatives than striking oil fields,” he said.

Alternative targets in Iran include government buildings, missile launch and drone launch platforms, and arms factories. Israeli news website Axios, quoting Israeli sources, reported that Israel’s strike on 26 October destroyed a component of Iran’s ballistic missile programme.

On 10 October, Israel’s Channel 14 also reported that Biden asked Israel not to strike Iran’s nuclear or oil facilities, to which Israeli Prime Minister Benjamin Netanyahu responded that this was a historic opportunity for Israel. Reuters, citing Gulf sources, said Gulf nations want the US to prevent Israel from attacking Iranian oil fields.

Asked if he would support this, Biden said: "It's in discussion." The comments spooked the market. "The fact that Iranian energy infrastructure could be a target isn't entirely new to the market," said Rebecca Babin from CIBC Private Wealth, speaking to Bloomberg. "But hearing Biden's comments brings this possibility closer to reality."

Iran has one of the most extensive refining capacities in the Middle East. Ten facilities produce around 2.4 million bpd.

There was "a degree of doubt" as to whether Israel would target Iran's oil, she said, because the White House had been "keen to keep oil prices stable ahead of the upcoming elections". Those elections have now passed, but the US is still fighting to control inflation. A war-induced spike in oil prices would not help. Bloomberg added that Washington had proposed Israel consider new economic sanctions on Tehran as an alternative to targeting economic infrastructure.

In April 2024, when Israel bombed the Iranian consulate in Damascus, oil prices were around $90 per barrel but have since dropped to around $70. Most analysts assume that prices would rise if Israel stuck Iran's oil facilities. Fitch Solutions thinks a full-blown war could push a barrel above $100, or even $150, if the Strait of Hormuz is closed.

Reserves and supply

Others are less pessimistic. ClearView Energy Partners, a consultancy, thinks an attack on Iran's oil or a blockaded Strait would increase prices by between $7-28 per barrel, while Bob McNally of Rapidan Energy Group told CNBC that "if 1.8 million barrels of Iranian oil are withdrawn from the market, prices are likely to rise by around $5 per barrel".

The banks took a similar view, citing high reserves. ANZ Bank said rising US oil stocks "show the market is well-supplied and resilient to potential disruptions," and investment bank Goldman Sachs said, "the geopolitical risk premium on oil prices remains modest despite rising tensions in the Middle East, primarily due to high spare capacity and recent limited production outages".

China's falling demand

The impact of supply disruptions is limited not only by high levels of reserves but also falling global demand. Tanker movements tracked by S&P Global suggest that Iran's crude oil exports have fallen sharply of late, averaging 816,244 bpd in the week ending 9 October. This is down from around 1.7 million bpd for the past year.

Oil demand has softened with slowing global economic growth, particularly in China, the world's largest oil consumer. Ole Hansen at Saxo Bank said China's demand had dropped by "a few hundred thousand barrels daily" from 1.3 million bpd in 2023. "We expect Brent crude prices to stay in the $70 range in the near term, with potential for positive surprises due to geopolitical events or a recovery in China," said Hansen.

Getty Images — Tugboats push the crude oil tanker Habrut to a reception terminal operated by China Petrochemical Corporation or Sinopec Group on January 30, 2023 in Zhoushan, Zhejiang Province of China.

Demand from other nations could be stronger, according to Goldman Sachs, which highlighted surprising oil demand growth over the last two years from the US and India, among others. Cuts to US Federal Reserve interest rates could also support demand if this leads to a weaker US dollar, cutting the cost of oil products outside the US.

In early October, futures for Brent crude for December delivery climbed to more than $76 per barrel, while contracts for West Texas Intermediate crude for November delivery rose above $70 per barrel. Goldman Sachs thinks Brent crude will trade within the $70-85 range, averaging $77 per barrel in the fourth quarter of 2024 and $76 next year, assuming no major supply disruptions occur.

Production and exports

Despite Western sanctions, Iran remains a major oil producer, supplying about 3 million bpd, or around 3% of global output. It exports around 1.8 million bpd to Asian countries through various terminals along the Gulf coast.

One such terminal, on Kharg Island, is particularly significant. Located in the northeastern Gulf near Basra, 25km south of the Iranian coast and 483km northwest of the Strait of Hormuz, it handles nearly 90% of Iran's crude oil exports to the world.

Anas Alhajji at the energy-focused website Attaqa said it was "difficult to target production sites directly, but the issue for Iran is that about 90% of its exports come from Kharg Island… this means the exports are concentrated in one location". He added that Israel would still need to breach the airspace of other Arab countries if it were to hit the island, "which poses a major problem". Israel would only impact the Iranian government's revenue and global markets if it targeted Kharg Island, he added.

Since Biden took office in January 2021, Iranian oil production and exports have increased, Alhajji said, adding the US had been "turning a blind eye to the sale of floating storage, which exceeded 70 million barrels in 2022... There seems to be a certain alignment between the Biden administration and the Iranian government."

Although OPEC has sufficient spare capacity to compensate for any loss of Iranian oil supplies, Iran could retaliate by targeting Gulf oil facilities

All eyes on OPEC

Although the Organisation of Petroleum Exporting Countries (OPEC) has sufficient spare capacity to compensate for any loss of Iranian oil, difficulties could arise if Iran retaliated by targeting oil facilities in neighbouring Gulf states, with 60% of the world's oil coming from the Middle East.

Citigroup analysts think an Israeli attack on Iran's oil facilities could cut 1.5 million bpd from the market. Analysts at Goldman Sachs think oil could spike by $10-20 per barrel "at its peak" if disruptions to Iranian production occur, assuming that OPEC+ partially offsets production losses, thus limiting price increases.

Eric Lee from Citigroup told Bloomberg that OPEC+ "holds approximately 6 million bpd in surplus capacity as a reserve," adding: "The large amount of excess oil could serve as a relatively soft cap on where prices might go." OPEC+ comprises OPEC's 13 member states plus ten other oil-producing states that coordinate output.

Coordinated response

According to Japanese bank MUFG, if the big Gulf oil producers cannot export oil due to disruptions in the Strait of Hormuz, there could be a significant, coordinated release of strategic oil reserves by the US, Europe, and Japan to prevent prolonged price increases and ensure supply security.

On 15 October, the International Energy Agency (IEA)—which manages emergency oil stocks for industrial nations—also sought to reassure markets, saying it was prepared to compensate for any supply disruptions from Iran if necessary. The IEA even anticipates a global supply surplus in 2025.

This helps to explain why oil prices did not surge after the recent Israeli-Iranian aggression, which has so far been limited to military and industrial targets. This restraint may in itself by a request from Israel's allies trying to control inflation.

Both Iran and Israel know they each have several options to escalate their conflict if needs be. Most of these options would see oil prices rise. By how much is still being hotly debated. Neither markets nor policymakers can afford to relax.

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