A US-Iran conflict would push oil prices above $150 - Capital Economics
Energy

A US-Iran conflict would push oil prices above $150

Energy Focus
Written by Caroline Bain

Mounting geopolitical tensions between the US and Iran have prompted fears of a full-blown military war in the Gulf region. The most important impact would clearly be the loss of life. From the perspective of the energy market, if war were to break out, we estimate that the price of oil would quickly surge to around $150 per barrel following the outbreak of hostilities.

  • Mounting geopolitical tensions between the US and Iran have prompted fears of a full-blown military war in the Gulf region. The most important impact would clearly be the loss of life. From the perspective of the energy market, if war were to break out, we estimate that the price of oil would quickly surge to around $150 per barrel following the outbreak of hostilities.
  • In this Focus, we analyse four major instances where geopolitical tensions led to a surge in oil prices because of the loss, or fears of a loss, in oil supply. The four periods are the OPEC export embargo implemented after the 1973 Arab-Israeli War, the 1979 Iranian Revolution, the 1990 Iraqi invasion of Kuwait, and the “Arab Spring” of 2011.
  • The common theme in these four major geopolitical events was that while the price of oil initially doubles or triples in the immediate aftermath, prices give up their gains relatively quickly. Indeed, actual shortfalls to supply are often less than the market initially expects. What’s more, output within the conflict area often recovers quickly, production outside the conflict region increases, strategic reserves are drawn down and demand typically falls owing to the higher prices.
  • We also examine what parallels can be drawn between the four historic events and the current situation between the US and Iran. Tensions between the US and Iran have increased over the past year, ever since the Trump Administration withdrew the US from the 2015 nuclear agreement known as the Joint Comprehensive Plan of Action (JCPOA) in May 2018. The US has re-imposed sanctions on Iran’s oil exports (among other sectors) and the country’s oil production and exports have slumped. However, we think that the loss of Iranian oil exports is now fully factored into prices.
  • That said, there would be a major impact on prices if there were a full-blown military war between the US and Iran, particularly if Iran responded by attempting to close the Strait of Hormuz (the world’s busiest oil shipping channel). If the Strait were to be completely closed, then about 20% of global oil supply could be lost, at least temporarily. Prices would skyrocket and, assuming prolonged tensions, we estimate that this would lead to the price of Brent more than doubling at least within the following year, but more likely almost immediately following the conflict. However, history suggests prices would fall back sharply in subsequent years as supply chains adjust and demand falters in the wake of higher prices.

A US-Iran conflict would push oil prices above $150

Rising US-Iran tensions have led many investors to question what would happen to oil prices if the situation were to escalate into a full-blown war. In this Energy Focus, we look at periods when geopolitics was the key driver of oil prices to try and quantify the impact of such an escalation.

Looking back at history

We identify four instances in the past where geopolitical tensions led to a loss of output (or stoked fears of a loss of output) and sent the price of oil soaring. These include the two oil price shocks during the 1970s, the 1990-91 Iraqi invasion of Kuwait, and finally the “Arab Spring” in 2011.

For the purposes of comparison, we have constructed a monthly real oil price series by deflating nominal oil prices using the US consumer price index which we have rebased to January 2019. (See Chart 1.)

Chart 1: Brent Crude Oil Price (US$ per Barrel)

Sources: Refinitiv, Capital Economics

The grey bars in Chart 1 show the spikes in the oil price that we think were mainly driven by geopolitical events.

There are a few obvious omissions from our analysis where we felt the impact (or perceived impact) of geopolitical developments on global supply was not the key driver of oil prices during these periods. The starkest example is the spike in oil prices ahead of the global financial crisis, but this was primarily driven by rapid economic growth in China.

What happened to prices?

1973: OPEC implemented an embargo on oil exports in October, aimed at targeting nations perceived as supporting Israel during the Yom Kippur War. The embargo was ultimately short-lived, and was lifted around six months later in March 1974. However, as markets immediately began to discount a significant supply shortfall, prices more than tripled in 2019 terms from around $25 per barrel to over $80. (See Chart 1 again.) Although prices subsequently fell back, they remained higher than before 1973. We think this reflected a structural change in the market as OPEC had flexed its muscles and demonstrated its ability to boost prices.

Many countries tried to mitigate against any potential re-occurrence of oil supply shortfalls in the future. Notably, the US’s response was the Energy Policy and Conservation Act (EPCA) which set up the Strategic Petroleum Reserve (SPR) and promoted energy conservation efforts.

1979-80: Civil unrest during the Iranian revolution disrupted the oil sector and led to a suspension of oil exports from Iran. Following the suspension, the price of crude oil more than doubled, to well over $100 in today’s prices.

It is worth noting that, in percentage terms, the 1973 crisis had a larger effect on real prices than the events of 1979, despite a much greater impact on global production in the latter. (See Chart 2.) That said, prices were coming from a low base in 1973.

Chart 2: Global Oil Production (Mn. BpD)

Sources: BP, Capital Economics

By 1983, global oil supply had fallen by almost 15% as the outbreak of the Iran-Iraq war in September 1980 led to lower production in Iraq too. However, a slowdown in the global economy (in part owing to higher oil prices) during the same period also shaved nearly a tenth off global oil consumption, which kept a lid on prices.

The two oil shocks of the 1970s prompted structural change in the market. Non-OPEC supply, notably in the North Sea, Alaska and Mexico, soared in the early 1980s and reduced the world’s reliance on Middle Eastern oil. On the demand side, a move away from oil in power generation in the OECD, most notably in Europe and Japan, began in earnest and the US fuel market was deregulated.

1990-91: Iraq invaded Kuwait on 2nd August 1990, resulting in a seven-month Iraqi occupation. Oil output from the two nations plunged, removing over 4m bpd from the market. Real prices rose from around $30 to a peak of nearly $70, although these gains were short-lived. (See Chart 1 again.)

To ensure a steady supply of oil, US President Bush approved a 5m barrel test sale and a 17.3m barrel official sale from the Strategic Petroleum Reserve (SPR) in September 1990 and January 1991 respectively. These both took effect in the months afterwards. (See Chart 3.) This, alongside a rapid ramp-up in Saudi supply, were among the factors which sent prices lower in the subsequent months.

Chart 3: US SPR & Oil Price During the Gulf War

Sources: EIA, Refinitiv

2011: Persistent political turmoil in the Middle East and North Africa put oil supply fears back on the table. The price of Brent crude broke $100 per barrel in February 2011 as political unrest in Egypt heightened anxieties that the Suez Canal (through which ~5% of global oil supply flows) might be closed, and that any broader political contagion could hit other oil producers.

In the end, physical supply was largely unaffected as the worst disruption was only in the relatively small producers, including Syria, Sudan and Yemen. What’s more, US production had started to grow strongly. But one year later an EU ban on Iranian oil imports ensured that prices remained elevated, despite a backdrop of downbeat prospects for global growth, particularly in the euro-zone.

What are the common themes?

While prices soar in the immediate aftermath of geopolitical events, in the weeks or months following such events these moves are typically unwound. We think this has two key explanations.

First, markets often move too quickly to factor a large shortfall in supply into prices. In many cases, the actual shortfall is much smaller-than-expected.

Second, in instances when there is a major drop on output, a ramp-up in production elsewhere or a drawdown of strategic reserves can allay fears of a supply shortfall and can calm speculative buying.

What parallels can be drawn today?

Tensions between the US and Iran have escalated recently, raising the prospect of a military war. (See our MENA Economics Weekly, Regional tensions go up a notch, rising chance of conflict”, published on 13th June.) We think that both sides are probably keen to avoid outright conflict, but that does not mean that an error of judgement or miscommunication could not spark a military war at any time. Indeed, the recent regularity of indirect attacks raises this probability.

At the same time, and as a result of US sanctions, Iran is struggling to sell its oil. With storage capacity now full, the country has been forced to slash oil production from an average of 3.8m bpd in 2018 to about 2.4m bpd currently. Out of this 2.4m bpd, only about 300,000 bpd (see Chart 4), approximately 0.3% of global supply, was exported in June 2019, according to Bloomberg.

Chart 4: Iran Oil Exports (Th. BpD)

Sources: Bloomberg, Capital Economics

We suspect that Iran’s oil exports will remain low over the coming months as the US sanctions are unlikely to be lifted any time soon. It is possible that some countries, including China and Turkey, will continue to buy oil from Iran but, even if they do, it will be on a relatively small scale.

Putting some numbers on the theory

Academic literature1 and theory suggests that the price elasticity of oil supply (PES – the responsiveness of the quantity supplied to a change in prices) is about 0.15 after one year. In other words, if global oil supply falls by 1% then prices will rise by 6.67%.

This means that the complete loss of Iranian oil exports (now reportedly at around 300,000 bpd) would only increase oil prices by an additional 2%. We think that this is plausible, not least because the loss in Iranian exports has already been discounted by markets.

Oil prices to surge above $150

The impact of the loss of Iran’s oil exports from here may be negligible, but markets could still worry that any further escalation in regional geopolitical tensions could lead to lower oil supply from the wider Gulf region. After all, it was the perception of a possible escalation of the Arab Spring in 2011-14 which led to higher oil prices rather than the actual loss of output.

In the most extreme case, Iran could attempt to shut the Strait of Hormuz thereby potentially blocking 20.7m bpd, or roughly 20% of global oil supply. If the market believes that Iran will fully succeed in achieving this then, using this PES measure, the price of Brent would jump from around $65 at the moment to just over $150 per barrel in twelve months (assuming that any war is prolonged).

Admittedly, if the Strait were to be blocked, prices are likely to surge well above $150 per barrel as part of a knee-jerk reaction. As it happens, most military analysts are sceptical that Iran would be able to block the Strait for very long. But that would not prevent a spike in oil prices.

We think that just as in previous episodes of oil price surges, such as during the 1990 Gulf War, any price jump would prove relatively short-lived. Markets tend to overestimate the loss of supply. Strategic reserves can be quickly drawn down, and any higher prices would incentivise an increase in oil production from areas outside the conflict.

This is particularly the case now as US shale production could be ramped up relatively easily and quickly (compared with conventional oil). There are currently thousands of drilled-but-uncompleted wells in the US which could be brought into operation to boost US oil production. Moreover, Saudi Arabia and the UAE have 3.8m bpd of spare pipeline capacity that they can use to export oil without having to go through the Strait of Hormuz. (See our Energy Update.)

In addition, if prices rise above $150 per barrel, some governments could give the green light to fracking industries. They are also likely to introduce measures aimed at raising fuel efficiency, renewable power generation, and the uptake of electric vehicles.

What’s more, if we are right in expecting weaker global growth to weigh on oil demand in 2019-20 (see Chart 5), that will also help to mitigate any supply shortfall.

Chart 5: Global GDP & Oil Consumption Growth

Sources: Bloomberg, Capital Economics

Conclusion

Overall, any further escalation in geopolitical tensions between the US and Iran is a significant upside risk to our oil price forecast. We estimate that prices could surge to over $150 per barrel by the middle of next year if tensions remain at a high level or war ensues. However, rising production elsewhere, particularly in the US, would act as a lid on prices.

[1]

  1. Baumeister, C. and Hamilton, J.D, (May 2019) ‘Structural Interpretation of Vector Autoregressions with Incomplete Identification: Revisting the Role of Oil Supply and Demand Shocks’, American Economic Review 109(5), 1873-1910.


Caroline Bain, Chief Commodities Economist, +44 20 7811 4055, caroline.bain@capitaleconomics.com
Samuel Burman, Assistant Commodities Economist, +44 20 7811 3911, samuel.burman@capitaleconomics.com
Kieran Clancy, Assistant Commodities Economist, +44 20 3974 7422, kieran.clancy@capitaleconomics.com

Written by
Samuel Burman Assistant Commodities Economist
Samuel.Burman@capitaleconomics.com +44 (0)20 7811 3911
Kieran Clancy Commodities Economist
kieran.clancy@capitaleconomics.com +44 (0)20 3974 7422