THE ECONOMIST: Will Middle East conflict between Israel and Iran push price of oil back up to $100 a barrel?

Ever since Hamas’s attacks on Israel a year ago, the biggest fear in oil markets has been that tensions would escalate into a full-blown regional war pitting Israel against Iran, the world’s seventh-largest producer of crude.

Until recently both countries seemed keen to avoid it. That explains why, despite the war in Gaza and Houthis firing missiles in the Red Sea, initial jitters on oil markets after October 7 last year soon gave way to the low and stable prices that have prevailed for much of this year.

But last week Iran fired around 200 missiles at Israel in response to Israel’s pounding of Hizbullah and other Iranian proxies. Now the world is anxiously waiting for Israel’s response.

Oil markets are nervous. Last week crude prices rose by 10 per cent, to $78 a barrel, their biggest weekly gain in almost two years (see chart). On October 7 they rose again, before whipsawing. When the last war involving a major petrostate broke out, in Ukraine in 2022, crude surged past $100 a barrel. Could that happen again?

To understand how high prices might go, look first at Israel’s options for retaliation. Were it to strike only military targets, such as missile-launch sites — and Iran responded moderately, in an attempt to defuse the situation — then some of the geopolitical premium boosting oil prices would evaporate.

But Israel could choose to escalate by bombing Iran’s civilian infrastructure, oil and gas facilities or nuclear-enrichment sites. Whichever Israel chooses, Iran may feel forced into a robust response, triggering a cycle that ends up turning Iran’s petro-industrial complex, the regime’s lifeline, into a target. So oil assets would not need to come under fire first for global markets to fret.

If Israel attacks Iran’s oil facilities, it may target assets that transform Iran’s crude into petroleum products. One possible choice is the century-old Abadan refinery, which provides the domestic market with 13 per cent of its supply of petrol.

Iran could offset some of the fuel shortages by smuggling more barrels from Iraqi Kurdistan, reckons Kpler, a data firm. The pain would remain local; such strikes may even boost the global crude supply as they could free up more of Iran’s unrefined oil for export.

If Israel wanted to deal a severe blow to Iran’s energy exports, it could go after the oil terminals on Kharg Island in the Persian Gulf—from which nine-tenths of all barrels of Iranian crude are shipped—or even the oil fields themselves. That would come at a diplomatic cost.

The Biden administration would be annoyed by the risk that petrol prices could jump less than a month before America’s presidential election. China, the destination for nearly all of Iran’s oil exports, would also be cross. That matters: China runs the port at Haifa, Israel’s largest, and is a big investor in the country’s tech sector.

Israel might still deem the cost worth bearing, and opt for hitting the terminals. A successful strike would instantly take a decent pool of oil off international markets: last month Iran exported a record 2m barrels per day (bpd), equivalent to nearly 2 per cent of world supply.

Even then, the global fallout would probably be contained. Unlike after Russia’s invasion of Ukraine, when the world was pumping oil at full tilt and demand was rebounding after the pandemic, supply today is plentiful and demand sluggish.

After a series of production cuts, the Organisation of the Petroleum Exporting Countries and its allies, collectively known as OPEC+, have more than 5m bpd in spare capacity—more than enough to make up for the loss of Iranian crude. Saudi Arabia and the United Arab Emirates alone have more than 4m bpd in reserve.

They probably wouldn’t wait long before raising output. OPEC+ members, angered to see their market share sliding in recent months, have been waiting for just such an opportunity to unwind their cuts. Last week they confirmed plans to lift output by 180,000 bpd every month for a year, starting in December.

Discipline is fraying in the cartel — Iraq and Kazakhstan have been overshooting their supply limits for months — which could push other members, not least Saudi Arabia, to restore their curtailed production even faster. The Saudis appear so determined not to cede further ground that they have reportedly dropped their target of returning oil to $100 a barrel, the level required for the kingdom’s books to balance as it embarks on a series of megaprojects.

Production is rising in America, Canada, Guyana, Brazil and elsewhere. The International Energy Agency expects non-OPEC output to grow by 1.5m bpd next year, more than enough to cover any rise in global demand.

And demand is slowing on account of tepid economic growth in America, China and Europe and a race to ditch petrol cars for electric ones, particularly in China. Before the latest escalation in tensions in the Middle East, traders expected an oil glut in 2025, pushing prices below $70 a barrel.

Today crude inventories in the OECD, a club of mostly rich countries, are below their five-year average. So a strike on Kharg Island would no doubt jolt markets. But prices would probably settle only $5-10 above their current levels.

Things could get much wilder were Iran to lash out at other countries in the Gulf it sees as supporting Israel. In recent years relationships between Iran and its neighbours have been stabilising: the country formally re-established diplomatic contact with Saudi Arabia in 2023.

In recent days officials from Gulf Arab states have met Iranian counterparts in Doha, the Qatari capital, to try to reassure them of their neutrality. Still, with few options available, Iran may seek to target the oil fields of its neighbours — starting perhaps with smaller Gulf states such as Bahrain or Kuwait.

The other tool Iran could use to create global chaos would be to close the Strait of Hormuz, through which 30 per cent of the world’s seaborne crude and 20 per cent of its liquid natural gas must pass. That would amount to economic suicide, since it would leave Iran unable not just to ship out any oil and other exports but also to ferry in many imports.

And it would greatly annoy China, which sources about half of its crude from Gulf countries. It is not entirely inconceivable that Iran resorts to this, however—especially if strikes or additional sanctions on its oil exports mean it can ship less crude than before.

It is hard to guess how the market would respond to such scenarios, if only because Iran’s actions would trigger further reactions from Israel, America and others. America and China, for example, would probably send their navies to reopen the Hormuz Strait.

Still, assuming disruptions are big enough to cause shortages of crude that last for a while, then oil prices would probably climb to the point where they curbed appetite for oil, after which they would start falling. Analysts believe such “demand destruction” would occur once crude hit $130 a barrel—roughly the level it peaked at in 2022.

Were oil markets to believe such a scenario even remotely likely, their fears would start to be reflected in the current price. Traders who had bet on prices falling in the near future would be rushing to unwind their positions.

Zoom out a little, however, and the recent rise in prices does not look striking, even by the relatively sedate standards of the past 18 months. In late trading on Monday they pushed past $80 a barrel.

Last year they averaged $82; in 2022, $100. The one-year-old conflict in the Middle East has confounded many expectations.

But for oil prices to reach triple digits again, a lot of things still have to go very, very wrong.