Heads in The Sand

Note: Since this article was written, the price of WTI crude has fallen from $65 to $22 due to the impact of coronavirus on economic activity in China and OPEC’s failure to reach an agreement with Russia over reducing oil output.

In 1938, the first drops of oil began trickling out of Saudi Arabia. Within 10 years, that trickle had turned into a deluge destined for Western markets. Since then, the price of oil has almost always reflected rising and falling tensions in the Middle East. Therefore, the oil market’s muted reaction to General Soleimani’s killing in an American drone strike earlier this year should come as a shock. That drone strike ignited already simmering tensions between the United States and Iran, but oil prices nudged upwards by just 4 percent. Talk about a new political risk premium on oil following an Iranian attack on a Saudi oil facility that cut global output by 5 percent last September also fizzled out after prices quickly fell below pre-attack levels.

There are two explanations for the oil market’s behavior. The boom in American shale production has diminished the Persian Gulf’s critical role in global oil markets. Since 2008, growth in American production has accounted for 73 percent of the increase in global output. Although the United States remains far from energy independent, the rapid rise in domestic production has reduced our reliance on imports. Theoretically, these developments should help insulate the price of oil from political instability in the Persian Gulf.

Political reality also shapes the market’s reaction to brinkmanship in the Middle East. American voters grumble about endless wars in the Middle East, and presidential hopefuls from both sides of the aisle have promised to withdraw troops from the region. Meanwhile, sanctions have devastated economic life in Iran. While content to attack American forces through its proxies, Iran does not want to provoke a war that would ruin its already limping economy. Because neither party seeks open confrontation, an incident like the one in January seems unlikely to escalate into all-out war.

However, these explanations discount the threat that instability in the Gulf poses to global oil supply. Iran has threatened to close the Strait of Hormuz in the past and developed its naval capabilities accordingly. Recent additions to Iran’s arsenal include anti-ship ballistic missiles and a speedboat fleet designed to attack larger enemy craft in swarms. According to analysts, successful closure of the strait would take 35 percent of global oil production offline and push the price of crude to over $100 per barrel. In recent years, the price of a single barrel has typically hovered around $60. Although heavy importers like China and India would bear the brunt of stratospheric energy prices, a downturn in the world’s second and fifth largest economies would trigger a global recession.

The prospect of improving U.S-Iran relations remains dim. After Jimmy Carter offered the deposed Shah refuge in the United States, the ensuing hostage crisis ended over a year later — the day Carter’s term ended. Animosity toward Carter precluded a deal from occurring while he still held office. The killing of a top general close to the Ayatollah marks a similar watershed moment in U.S-Iran relations. Iran will dismiss diplomacy with the United States as long as Trump is president, and tensions will worsen before they stabilize. Oil has become a broken barometer for tensions in the Middle East, and markets have not yet priced in geopolitical risk.



Categories: Foreign Affairs

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1 reply

  1. Too much has been drilled and now no matter what the relationship of countries are with each other, demand-supply issue is here to stay for quite sometime and oil producer countries would continue to struggle keep their economy growing.

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