Middle East Crisis Bringing US $100/Barrel Oil?

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Despite the continuation of hostilities between Israel and Lebanese guerrilla group Hizbullah, the oil price has fallen from its US$78/barrel (Brent) peak and is now trading around US$74/b on expectations that Iran will not become involved. Nevertheless, given supply tightness in the oil market, the floor level for oil in the coming months is probably around US$70/b. If, as we expect, the current situation evolves into a prolonged, sporadic and low-level conflict, the price will be closer to US$80/b. And if Iran is drawn into the fighting, the price will probably exceed US$100/b.

Before the onset of the current crisis in the Middle East, Brent had been trading at around US$65-70/b. On the demand side, the price has been supported by strong demand from non-OECD economies, principally China; OECD demand growth, by contrast, has been sluggish. From the supply side, the main problems have been a relatively low level of spare capacity and insufficient quantities of light, sweet crude—which is the preferred feedstock for existing refining capacity, especially in view of the products currently in the greatest demand (mainly middle distillates such as jet fuel). In this regard, production problems in Nigeria are particularly unfortunate, as that country is a prime producer of light, sweet crude. Saudi Arabia’s idle capacity, by contrast, is for sour, heavy crude.

Risk Premium

The oil price was in any case likely to rise in the third quarter, in response to the start of the so-called driving season in the US, but the eruption of hostilities between Israel and Hizbullah—which has now been running for nine days and is estimated to have resulted in 300 deaths and the displacement of 500,000 Lebanese citizens—pushed the price significantly higher. Given supply tightness, the oil market is especially sensitive to any political risks in the Middle East, which remains the world’s principal oil-producing region.

The main source of concern in this case is Iran, which backs Hizbullah and has threatened Israel with serious consequences if Israeli forces attack Syria (Hizbullah’s co-sponsor). Even before the crisis, Iran was a source of concern for the oil market, because of the stand-off with the US over Tehran’s nuclear programme. This could conceivably lead either to international sanctions or US military strikes against Iran, in which case Tehran would probably respond by halting oil exports. The onset of Israel/Hizbullah fighting, and the potential for it to escalate to the point that Iran became involved, put these concerns to the fore. Iran produces 4.3m barrels/day at present and exports around 2.6m b/d. Because global spare capacity is now around 2m b/d—down from 5.75m b/d in 2002—the cessation of Iranian supplies would be catastrophic for the world’s oil market.

Where Are Prices Heading?

The softening of the oil price over the last week, from US$78/b, reflects a confidence in markets that Iran will not be drawn into the fighting. But where are prices likely to go in the next few months?

The Economist Intelligence Unit foresees three possible outcomes for the current conflict. The most positive is for a swift end to hostilities, in the context of a negotiated ceasefire, followed by the rapid deployment of Lebanese or international forces to southern Lebanon in order to suppress Hizbullah and so remove the rationale for Israeli military action. In this scenario, the oil price would probably soften a little, although US$70/b would likely prove to be the floor level.

The second scenario, which is our baseline, is for a prolonged conflict between the two sides. Israel would maintain a sizeable military force on its border. Its aim would be to create and maintain, via air and ground strikes, a security zone stretching into southern Lebanon which Hizbullah could not use to mount rocket attacks on Israeli territory. In this scenario, the oil price is likely to be in the US$75-80/b range.

Our third scenario is for the conflict to escalate, drawing in Iran (perhaps via Syrian involvement). Although the oil market is reasonably confident that this will not happen, the risks of escalation cannot be dismissed. Both Iran and Syria have track records of miscalculation when engaging in brinkmanship in times of crisis. This increases the risk that the conflict could escalate swiftly beyond the limits currently envisaged by any of the regional actors. In this scenario, US$100/b would probably be the floor price for oil—sending the world economy into new and unwelcome territory.