The Israel-Hamas conflict ignites "war premium," will oil prices return to $100?

On June 13, the three major U.S. stock indices fell sharply due to market concerns over the conflict between Israel and Iran. Although there has been a significant amount of rhetoric between the two countries over the past few decades, and conflicts have occurred before; however, there are worries that this time it could escalate the situation to a whole new level of disaster. Any war, especially one that may require U.S. intervention to defend allies, poses a downside risk to the market. The costs of war are high, not only in terms of loss of life but also in the wealth destroyed during the conflict.

For most aspects of the economy, the escalation of conflict in the Middle East will generally have a negative impact. However, there are two industries that may rise due to the intensification of conflict: the first is the defense industry, and the second is the oil industry. In fact, despite the decline in major market indices, concerns over potential supply disruptions have pushed up oil prices. On June 13 alone, WTI crude oil prices rose by 7.6%, with an increase of over 10% at one point. This "war premium" provides opportunities for oil investors, at least somewhat alleviating the pressures faced by the industry this year amid trade wars and broader economic concerns.

Conflict May Escalate

In an operation known as "Operation Lion's Rise," the Israeli government made a bold decision to deploy over 200 aircraft and drones to attack key military targets within Iran. This operation commenced in the early hours of June 13, primarily targeting nuclear facilities, but also involving the country's military, missile, and command centers, including the capital Tehran and several other cities.

During the first term of the Trump administration, Trump decided to terminate an agreement that had successfully prevented Iran from further developing its nuclear capabilities. Although Iran complied with the agreement, he believed that Iran's continued development of other capabilities and ongoing violent threats against the U.S. and Israel were sufficient reasons for him to withdraw from the agreement and impose severe sanctions on Iran. Since then, there has been increasing concern that Iran would further develop its nuclear capabilities and ultimately take significant military action against the U.S. and/or Israel. The last straw may have been the recent harsh criticism of Iran by the International Atomic Energy Agency (the UN's nuclear oversight body), due to the country raising its uranium enrichment level to 60% earlier this year, marking the first time in nearly 20 years that Iran has been found in violation of its non-proliferation obligations.

Israel's attack undoubtedly escalated the situation further. This is because Israel also launched additional strikes on other military bases, nuclear facilities, and the Mehrabad Airport on the outskirts of Tehran, prompting Iran to retaliate against Israel. Iran's counterattack included the launch of numerous drones and ballistic missiles, some of which resulted in casualties, with many missiles not only targeting Israel but also flying over Jordan, Syria, and Saudi Arabia. Additionally, the Houthi forces in Yemen also took actions against Jerusalem.

Supply Disruption Risks, Oil Prices Trend Upward

These events and any further escalation will undoubtedly have a positive impact on the oil industry. During the first term of the Trump administration, severe sanctions imposed on Iran significantly reduced the country's oil production. From 2017 to 2020, Iran's daily oil production fell from 4.76 million barrels to 3.01 million barrels, a decrease of 36.8%. However, during the Biden administration, Iran's oil production began to rebound. This was not due to the lifting of sanctions on Iran, but rather because Iran became more flexible in oil transportation, and certain countries received temporary exemptions to increase their purchases of Iranian oil exports. The end result was that last year, Iran's daily oil production rose to 4.68 million barrels.

The global oil market is in a delicate state of oversupply. As seen in the chart above, the daily production and consumption of crude oil globally, along with the surplus supply over the years, are illustrated. For example, last year, global daily crude oil production exceeded daily consumption by about 60,000 barrels. On its own, this number may not seem large. However, over the course of a year, it results in an excess of 21.9 million barrels of crude oil. It is estimated that by 2025, supply will exceed demand by 820,000 barrels per day, equating to an excess of 299.3 million barrels of crude oil. The forecast provided by the U.S. Energy Information Administration (EIA) indicates that next year, supply will exceed demand by 560,000 barrels per day, or an excess of 20.44 million barrels of crude oil.

The situation regarding oil prices is quite complex. Since the industry is primarily priced in U.S. dollars, fluctuations in the value of the dollar relative to other currencies will impact prices. Concerns about economic conditions will also affect prices. However, it is worth noting that typically, a balanced oil market should see the commercial inventory levels of OECD member countries fluctuate between 50 to 60 days of supply. Once this range is exceeded, prices will experience significant volatility.

For example, in the chart below, the WTI crude oil price shows a certain inverse correlation with commercial OECD inventories (measured in days of supply). The increase in supply days from 2013 to 2016 led to a corresponding decrease in prices. From 2017 to 2019, there was a decrease in supply days, while crude oil prices rose. In 2020, the oil price plummeted due to the COVID-19 pandemic, which was caused by a significant increase in commercial OECD inventories, but this was due to a sharp decline in demand. If we use estimated data for this year and next year, we can see that the gradual increase in supply days corresponds with a decrease in prices

The losses caused by supply disruptions from the Middle East conflict may far exceed the current gap between global supply and demand. This is not only because Iran's crude oil production may decrease, but also due to the overall possibility of supply disruptions in the region. This is related to the Persian Gulf and the Strait of Hormuz within it. The Strait was referred to in 2023 as "the world's most important oil passage," responsible for transporting about 20.5 million barrels of crude oil daily. This includes not only Iranian crude oil but also crude oil from Saudi Arabia, Kuwait, Iraq, and the UAE. Qatar is also affected, as the country, being the world's largest liquefied natural gas exporter, transports almost all of its liquefied natural gas through this strait.

Overall, about 20% of the oil used globally each day is transported through this region. Given the strait's influence, Iran has long used it as a political bargaining chip. This includes actions taken in most years, including 2023, 2022, and 2021. Sometimes, these actions are relatively minor. But in certain cases, such as in January 2021, the actions may be more significant. In that month, the Iranian government seized a South Korean-flagged tanker in the Gulf waters and detained its crew. In May 2019, four vessels, including two Saudi-owned tankers, were attacked outside the Strait of Hormuz. Some related countries can bypass part of the oil around this region. However, most oil cannot bypass this region. With the decline in Iranian oil production and disruptions in maritime transport, even a theoretical reduction of 1 million barrels per day in global supply could lead to a significant increase in oil prices. If a full-scale war breaks out (which seems increasingly likely), it would not be surprising for crude oil prices to rise to $100 per barrel or higher.

Goldman Sachs analysts raised their oil price forecasts for the coming months by $2 to $3 per barrel last week, but also listed a range of scenarios: the worst-case scenario is that oil prices soar above $100 per barrel. JP Morgan also predicts that the closure of the Strait of Hormuz could push international oil prices up to $130 per barrel.

Conclusion

Currently, this is a significant time for investors in the oil industry. From all perspectives, war is a bad thing. It consumes funds, takes lives, and triggers various problems. However, for the oil industry, it has been under increasing pressure in recent months due to concerns that the global economy may decline due to the ongoing trade war. For those who are generally optimistic about oil, this may be a good time to consider investing in it, such as investing in oil and gas exploration companies