Oil Market Risks Start to Resonate

Geopolitical Risks Harder to Ignore

With fundamentals strong and inventories lean, markets will remain wary of geopolitical risks to supply, as the price rise over the past two weeks has illustrated. The volatility that characterized markets last year is also likely to return, as paper traders pay greater attention to geopolitical events. The threat of escalation has been a concern for markets since October, especially any signs that the war was extending to Iran. A wider war between Israel and Hezbollah that could drag Iran more directly into the ongoing conflict could be one catalyst for escalation. Thus far, all-out conflict on Israel’s northern border has not materialized, despite thousands of cross-border rocket and missile attacks since October and recent Israeli strikes deeper into Lebanese territory. Hezbollah’s aversion to a potential political backlash if it drags Lebanon into war, as well as U.S. pressure on Israel, have probably helped to keep the conflict from widening.

Recent events suggest it will become harder to contain such risks. An April 1 airstrike on Iran’s embassy compound in Damascus killed seven members of Iran’s Revolutionary Guards, including a senior Quds Force commander who previously led operations in Syria and Lebanon. The United States and Israel are preparing for Iranian attacks on their assets in the region. Yet Iran will probably be wary of actions that will drag it into a direct confrontation with Israel or the United States, and past experience shows that a spectacular immediate response is not the likeliest outcome.

Iran may instead opt for “strategic patience” and a response that leverages its proxy forces and allied militias throughout the region. When the United States killed General Qassem Soleimani in a January 2020 drone strike, Iran responded by launching missiles at U.S. bases in Iraq that did relatively little damage, and it refrained from a wider immediate assault. In the past week, Iran’s president and Hezbollah’s leader have vowed to respond to the Israeli strike. But such a response may again feature symbolic attacks meant to signal Iranian resistance and defense of its interests, rather than a more brazen approach such as a Hezbollah rocket assault on Israel. The past few months have shown that Iran’s “axis of resistance” enables it to cause trouble throughout the region. Iran could encourage missile or drone attacks on U.S. troops in Iraq and Syria, scale up tanker attacks and sabotage in the Persian Gulf (Iran maintained plausible deniability for a series of such attacks in 2019), and increase its support for the Houthis. It is also possible that Iran could lash out against U.S. or Israeli interests outside the Middle East. These actions would be in keeping with Iran’s reliance “on the diversity and dispersion of its tools to make its adversaries reluctant to respond directly.”

Beyond the immediate threat of Iranian retaliation, there is a long-term risk associated with domestic political dynamics in Israel. Prime Minister Benjamin Netanyahu remains a particular wild card. His domestic popularity is sinking, and he faces the possibility of prosecution if he is removed from office, so Netanyahu has personal political incentives to extend the war, not just in time but also in scope. Israel’s recent strike in Damascus was part of an ongoing shadow war with Iran, but it also appeared designed to goad Tehran into more open retaliation. Escalation, even just against Hezbollah, would stretch the Israel Defense Forces operationally. Nevertheless, it would reinforce Netanyahu’s claims that Iran remains an existential threat to Israel that must be countered.

There are several important implications for the oil market. The biggest risk is that escalation draws Israel and Iran into more direct confrontation, which would put Iranian production at risk and raise the possibility that Iran could disrupt the 18 million b/d of oil flows through the Persian Gulf. Unlike the Red Sea, there are no alternative routes for Gulf shipping. If any such disruptions materialized, their impact on prices would be seismic given the volumes at risk. But even a heightened sense of threat will add a geopolitical premium to prices given current and anticipated fundamentals. 

These risks could ramp up just as the market is expected to tighten in the second and third quarter and the summer driving season begins in the United States. An oil price of $90 per barrel is no doubt causing anxiety in the Biden administration, which recently canceled its latest solicitation to help refill the Strategic Petroleum Reserve (SPR) due to higher prices. The Department of Energy has been gradually refilling the SPR, which now sits at 364 million barrels. If market…