It Just Does Not Add Up
In an unpredictable investment environment, the horrific attack of Hamas on Israeli civilians and the similarly brutal retaliation from the Jewish state has created further uncertainties. The outcome of the Israel-Hamas war cannot be prognosticated therefore its impact is impossible to foretell. The good news is, if there is any, that atrocities have, so far, been constrained to the two warring parties but in case the conflict becomes a regional conflagration the global economy and the global oil balance will be severely and adversely affected. The tension that flared up in the most important oil producing region of the world has not had a palpable impact on oil output albeit some geopolitical risk premium has inevitably been built in the price. After all, Middle East crude oil output is around 23 mbpd. Below we attempt to provide answers to what hopefully will turn out to be an academic question: how would oil prices react to supply disruptions?
There are several approaches. History could provide a background of what to expect in case the whole region is turned into a battlefield. There have been three major oil price shocks that originated from the Middel East in the past 60 years: two in the 1970s and one in 1990. During the 1973 Yom Kippur war OAPEC countries imposed an oil embargo on the US and its allies because of the US supply of Israel with military equipment. Although global or regional oil output was never affected the price of oil increased fivefold due to export restrictions, from $2.5/bbl in 1972 to $11.5/bbl in 1974 in nominal terms, according to BP’s Statistical Review. Because of elevated tensions in the region the price never retreated, and the next upside impetus arrived in 1979, during the Iranian revolution. The protests against the Shah, Mohammad Reza Pahlavi and the ultimate ascent of Ayatollah Khomeini to power devastated Iran’s oil industry. Between 1979 and 1980 OPEC’s oil production fell from 30 mbpd to 26 mbpd and this 13% decrease in output was more than enough to push the price of oil from $13/bbl in 1978 to $35.7/bbl in 1980. In 1990 Iraq’s invasion of Kuwait sent prices from $15/bbl up to $41/bbl in the space of less than a year as the loss of oil supply was anywhere between 4.5 mbpd and 5.2 mbpd, the OIES estimated back then.
History, however, is nothing but a dubiously reliable guide to the future, especially in modern times when reliance on oil diminishes with the transition firmly under way and non-OPEC market share also on the rise. Probably the most reasonable way to predict the impact of a potential supply disruption is to use the faithful inverse relationship between global and OECD oil inventories and oil prices and examine the possible scenarios under which the region’s oil supply might be disrupted. We have drawn up three arbitrary prospects. The most plausible event is Iran’s indirect involvement, which would probably force the US to re-impose practical export ban on the Persian Gulf OPEC member. Under this scenario as much as 1 mbpd could be taken off the market. (Iran’s current output of 3 mbpd compares with 2.1 mbpd in January 2021.) The move might add $6-$7/bbl to the price of oil.
In case of further escalation, the key chokepoint, the Strait of Hormuz could come under blockade. There are around 17 mbpd of oil sailing through this key artery and the closure of the strait would result in a more significant jump in prices. Of course, the impact of such a development could be mitigated by relying on the spare capacity of Gulf producers, underground storage and pipelines that circumvent this critical shipping passage. If one assumes the loss of 6-7 mbpd of oil supply/exports the price impact would probably be around $20/bbl.
Armageddon would take place if the whole region went up in flames. The Houthi attack on Saudi oil installation in September 2019 is still fresh in memories. The Kingdom’s was forced, albeit briefly, shut in 5.7 mbpd of production, nearly half of its output. The market reaction to the incident was an overnight price jump of $10/bbl before nerves were calmed, largely thanks to the Saudi assurance that exports commitments will be honoured from stockpiles. Assuming a combined supply disruption of 15 mbpd from the region, however short it would be, a rally above $130/bbl would probably be a conservative estimate as financial players will, as they always do, exaggerate the actual impact of the supply shortage.
The influence of the Israeli-Hamas war on the underlying physical oil balance has been non-existent, so far. Oil is struggling to approach the highs seen in mid-October after the initial panicky reaction subsided. Nonetheless, the chances of some type of output setback will rise as the war drags on and depending on the extent of it the repercussions could stretch from concerning to dire.
06 Nov 2023