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Oil Markets Underestimating the Risk of a Middle East Blowout

Last week, the Israeli government ordered its state-run electricity company to halt power supply to the Gaza Strip days after Palestinian militant group Hamas launched a surprise attack on the country. The Israeli prime minister’s office revealed that the security cabinet has approved several steps to destroy the military and governmental capabilities of Hamas and Islamic Jihad “for many years”, in a war that has seen more than 3,000 Palestinians and about half as many Israelis killed.

But now there’s a growing risk this could escalate into a regional conflict after Lebanon-based Hezbollah warned that it’s ready to fully enter the war in support of Hamas. Indeed, there are growing fears that Hezbollah may open a new front against Israel at the behest of its leaders and their Iranian backers while Iran has warned of preemptive action against Israel if it goes ahead with a ground offensive.

And some commodity experts are now saying the oil markets have underpriced this risk, and oil prices could skyrocket if the situation above unfolds. Commodity analysts at Standard Chartered have pointed to a medium-term reduction in Iranian oil exports as being the most likely consequence of shifts in the geopolitical landscape. Back in August, we reported that Iran oil exports had hit record highs thanks in large part to the Biden administration opting to look the other way as Tehran boosts production ostensibly in a bid to keep markets well supplied and oil prices low. Related: Can Guyana Avoid The Resource Curse?

The price response to the escalation in the Middle East tensions has so far been modest; however, the Israel-Gaza war is likely to cause a significant shift in U.S. policy on Iran due to its open support and backing for Hamas.

Constraints on Iranian oil exports were eased after the signing of the Joint Comprehensive Plan of Action (JCPOA) in 2015 but tightened again after the U.S. withdrew from the JCPOA during the Trump administration, with output falling below 2 mb/d in 2020 when waivers given to consuming countries were withdrawn. Iran’s oil output and exports have increased sharply under the Biden administration, with production hitting 3 mb/d, including 500,000 b/d in the current year, while exports sit just under 2 mb/d.

StanChart says that changes in positioning in the oil futures markets have been modest despite a significant increase in volatility. The analysts note that it is not an extreme tail of the distribution as might be expected in a full-blown Middle East crisis, adding that speculative positioning is also not extreme, particularly in Brent. The latest fund manager data shows that prices are about USD 6 per barrel (bbl) lower than in late September, despite no significant loosening in fundamentals. StanChart says that the Middle East geopolitical risk is currently being significantly under-priced and that current fundamentals alone are enough to justify a complete reversal of this month’s price undershooting.

If anything, oil fundamentals have strengthened considerably. According to StanChart, global oil demand has already exceeded the pre-Covid oil demand set in August 2019, averaging 102.33 million barrels per day (mb/d), good for a m/m increase of 1.2 mb/d and a y/y increase of 2.3 mb/d. The analysts have refuted arguments by some Wall Street analysts that high oil prices have already triggered demand destruction.

A couple of weeks ago, JPMorgan analysts warned that oil demand will decline in the current quarter due to the previous nearly 30% rally in oil prices in the previous quarter.

‘‘After reaching our target of $90 in September, our end-year target remains $86 [per barrel]. Moreover, demand restraint from rising oil prices is once again becoming visible in the US, Europe, and some EM countries,” reads the note titled “Demand destruction has begun (again).

China and India drove global oil demand growth this year, but China opted to draw on domestic crude inventories in August and September after oil prices surged. There are already signs that consumers have responded by cutting back on fuel consumption,” wrote Natasha Kaneva, head of the global commodities strategy team at JPMorgan.

That bearish thesis could have some validity considering the mixed crude and distillate trends coming from the U.S. Last week, U.S. crude oil inventories rose 10.18 mb w/w to 424.24 mb, reducing the deficit below the five-year average by 5.96 mb to 13.90 mb. However, crude oil inventories at WTI’s pricing hub in Cushing, Oklahoma, remained close to the operational minimum, falling 0.32 mb to a 15-month low of 21.77mb.

Thankfully, fuel prices have continued falling despite the latest uptick in crude prices. A gallon of gasoline is currently retailing at a national average of $3.575, lower than $3.881 a month ago and $3.870 a year ago while diesel is selling at $4.464 a gallon from $4.575 a month ago and $5.304 a year ago.



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