Last Friday, the Middle East once again faced the prospect of a severe escalation in armed conflict, when a targeted US airstrike killed Iranian general Qasem Soleimani, one of Tehran’s most powerful leaders. Typically, these sort of tensions would be expected to significantly drive up oil prices amid fears of a violent supply disruption; Saudi Arabia, the world’s third-largest oil producer and a source of significant spare short-term oil capacity is a regional neighbour of Iran and at risk of becoming embroiled in a potential conflict. Moreover, around 20% of the global oil trade passes through the Strait of Hormuz, where Iran has already shown it is capable of disrupting shipping. And those concerns are not without merit; analysis by Fathom last year showed that a pause in shipping through Hormuz could cause oil to appreciate by up to 250%, with significant implications for the global economy.
Against this backdrop, the market reaction to the latest incidents in the region has been rather muted. While the price of oil briefly rose by around 4% following the US airstrike, it has since fallen again. This follows the pattern seen after previous incidents in the region after the US withdrew from the Iran nuclear deal in May 2018. In the wake of several events, for example the missile attack on Saudi Arabian oil facilities which briefly took up to half of the country’s production offline, the price of oil rapidly fell back to its pre-event level. Indeed, the December decision by OPEC+ (including Russia) to further cut its production, which was not directly related to geopolitical tensions in the Middle East, led to one of the most sustained rallies in oil prices in recent months.
There are several possible explanations for the markets’ relatively mild reactions to the tensions: investors may be underappreciating the tail risk to prices under a material escalation which leads to a persistent supply disruption; market participants do not think that there is a high risk of tensions in the region escalating to that extent, because tensions have tended to recede marginally in the wake of escalations; or, other features in the global oil market make prices less susceptible to supply fluctuations from the Middle East.
Indeed, the unabated rise of the US shale industry has made the US the world’s largest oil producer, and in turn diminished the role of the traditional OPEC producers in the global market.
Since 2016, OPEC+ has seen its share of global production fall by around 5 percentage points; the increasing share of the US accounts for the bulk of this loss. While this shift makes the global supply less susceptible to region-specific shocks, OPEC’s influence in the market remains undisputed, as the reaction to its December meeting showed.
Another compelling explanation for the oil price’s relatively underwhelming response to geopolitical news is the importance of demand-side factors outweighing the supply side. Perhaps the primary factor driving global growth over the past two years has been China, both due to concerns over domestic economic performance, and the impact of its trade tensions with the US. The chart below shows how, since the beginning of last year, the oil price has moved much more in step with our proprietary China Exposure Index (CEI), a proxy of market sentiment relating to the US–China conflict, than it did previously. As hopes for a preliminary trade deal between the two adversaries grew in the second half of 2019, both our CEI and the price of oil made gains. However, whenever a change in mood-music around the negotiations led to a softening of the CEI, crude oil followed suit. While significant upside tails risks to the oil price remain in the event of a significant political escalation and outage of much of OPEC’s oil exports, markets currently appear to believe much of the uncertainty around oil is already priced in and are consequently more cautious in responding to news from the Middle East.
The charts in this article have been created using Chartbook on Datastream. The Chartbook, created and maintained by Fathom Consulting, is a library of over 9000 charts, containing up-to-date macro and financial market data for over 170 countries. Whether it is a particular topic, country or variable you are interested in charting, the Chartbook has everything you need. Simply type search ‘cbook’ into your Eikon search bar or click the ‘Chartbook’ tab on Datastream to find out more.
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