Oil Markets Were Unwise But Right in the Israel-Iran Crisis

The Middle East seemed to be on the brink of war last week and oil prices fell. Was the market wrong?

Brent futures price closed at $90.45 per barrel on Friday, April 12 before Iran’s missile and drone attack on Israel (Figure 1). When markets opened on Monday, April 15, prices rose less than $1 before ending lower and closing at $90.02 on Tuesday. After Israel’s counter-attack on Friday, April 19, Brent rose from $86.96 to almost $91 only to close at $87.29.

This seems remarkable considering that oil flows through the Persian Gulf could have been disrupted. About 15.5 mmb/d (million barrels per day) of crude oil pass through the Strait of Hormuz (Figure 2). There’s an additional 5 mmb/d of refined products, and 10 bcf of liquefied natural gas.

There was a time when military outbreaks in the Middle East would have caused a sharp increase in world oil prices. Figure 3 shows a comparison of Brent price in the one hundred days following the 1990 Iraqi invasion of Kuwait and after the 2023 Hamas attacks on Israel.

It’s worth pointing out that there is no major oil production in Israel or in surrounding countries. The involvement of Iran in the recent conflict, however, makes these two events comparable at least in the last few weeks.

There are a slew of mainstream narratives for oil market’s phlegmatic reaction to recent attacks in the Middle East.

“Traders aren’t buying that either Israel or Iran is actually interested in escalating the tensions and are merely engaged in largely symbolic, face-saving exercises. These skirmishes did not impress the oil markets which believes that no disruption to oil flows will occur.”

Manish Raj, Managing Director at Velandara Energy Partners

Some analysts argue correctly that the Persian Gulf has never been closed to oil flow although the so-called “tanker war” during the 1980-1988 Iran-Iraq conflict came close.

“Oil traders doubt the country would ever close the strait entirely because that would prevent Iran from exporting its own petroleum. Moreover, Iran’s navy is no match for the US Fifth Fleet and other forces in the region.”

Julian Lee, Bloomberg Oil Strategist

Others have made the point that Saudi Arabia and other OPEC+ members have more than 5 mmb/d of spare production capacity in case of a supply interruption. The problem is that most of that oil would have to pass through the Persian Gulf.

Still others like Rystad Energy explain that a war “risk premium” of $5 to $10 was already built into oil prices.

Bankers and economists can always be counted on to reduce energy to a some exponent in the Cobb-Douglas Production Function in a way that ignores the real world.

“If we have an oil shock, it will be against a backdrop of general disinflation in all other factors.”

Klaas Knot, President of De Nederlandsche Bank

There is, of course, truth in all of these arguments but they do not fully capture the potential threat to energy and to the world order that a hot war in the Middle East might cause. Bloomberg analyst John Authers got closer to what seems relevant in an opinion column that he wrote last week.

“As a rule, geopolitical crises have little impact on broader markets. The 1973 Yom Kippur War led to the Arab oil embargo and was hugely significant. But none of the eruptions in the Israel-Palestinian conflict over the years have translated into problems for global markets. There is no oil between the Jordan River and the Mediterranean, so no risk to global energy supply, unless it escalates.

“The nations attacked each other in ways designed to avoid escalation while sending a message.”

John Authers

Using Authers’ approach (in Figure 1), I adjusted Brent prices to March 2024 U.S. dollars for geopolitical crises from 2018 to the present.

Brent price increased only 10% during the latest Middle East crisis from inception in October 2023 to the maximum value (Figure 4 red line). By contrast, when U.S. President Trump announced sanctions to eliminate Iranian oil exports entirely in 2018, adjusted Brent price increased 26% (blue line). In 2019 when Houthis attacked Saudi Arabia’s main refinery complex, price briefly increased 15% before normalizing (magenta line). During the 2022-2023 Russian invasion of Ukraine, Brent rose 78% (brown line).

Perhaps the most perplexing aspect of the market’s response to recent events in the Middle East is that the highest price was just after the Hamas attacks in October 2023 when CPI-adjusted Brent reached almost $94. The direct attacks between Iran and Israel in April resulted in a lower price maximum of just more than $91.

The data in Figure 4 suggest that markets evaluated each geopolitical situation differently and assigned considerably more price and supply risk to some events than to others. Curiously, recent events between Israel, Iran and its Gaza surrogates seem to have been judged to have had the lowest risk based on this approach.

Many believe that markets are always right. It’s important, however, to understand what that means.

Markets focus only on the margin. That means examining the costs and benefits of a small or marginal change in the price or supply of oil, in this case. It’s a never-ending calculation of the difference between one feasible alternative and the next feasible alternative. How will net benefits and costs change if oil price increases by one unit?

The sum of those analyses is often mistaken for market wisdom. It’s not.

Oil-price volatility is a reasonable proxy for how markets evaluate marginal analysis. Figure 5 below shows implied Brent price volatility for the geopolitical events shown in Figure 4 (above).

The duration and amplitude of oil price volatility during the 2022-23 Ukraine invasion were extraordinary compared to other recent geopolitical crises. More than any other factor, this seems to explain why the cumulative price response for this event was so much greater than for the others.

Conversely, the amplitude of recent Israel-Iran-Hamas volatility was lower than for other events.

In other words, markets are really responding to the duration of uncertainty at the margin and not to the potential risk to oil supply. After the initial Hamas attacks in October 2023, it became clear that Israel would not respond immediately and later, that there was no proven link between the attacks and Iran. This conflict would most likely be limited to Gaza.

When Iran attacked Israel in April, it sent direct messages that its actions were now complete as long as Israel’s reaction was limited. It was.

That didn’t and doesn’t mean that the crisis is over or that there is no further risk for oil price or supply. It simply means that the benefits to the market of higher oil price did not justify its cost at the time. As Bloomberg’s Grant Smith accurately noted,

“It still seems incredible that, in the wake of reciprocal attacks by Iran and Israel, crude prices are faltering.

“On the one hand, the pullback is entirely rational…But the market’s calm could also be seen as misguided.”

Bloomberg (April 23, 2024)

Markets are almost always right on the margin, today. It’s a mistake to believe that markets are considering anything more. I wonder how many analysts understand this. Markets are only concerned with financial benefits to investors, not general benefits to society.

The outcome for now of recent events in the Middle East seems to justify the limited price response. It was an incredibly risky gamble by the market because its interests are not society’s.

Markets contain the collective knowledge of its participants. Knowledge is not the same thing as wisdom.