Crude reality: oil market in an era of surging risk premium

The outbreak of aerial warfare between Israel and Iran since January 13 and the resulting surge in crude’s risk premium is a stark reminder that no matter how carefully and dynamically market stakeholders calibrate global oil supply and demand fundamentals, geopolitical flashpoints can erupt without warning to upend all assumptions and strategies.

What makes these situations especially challenging is the near-impossibility of mapping out every potential escalation scenario – along with its cascading effects on Middle East oil supply – and assigning each a probability. It’s an exercise in futility.

Looking to historical precedent offers little guidance. Geopolitical dynamics, national agendas, and the political actors involved in the matter or holding influence on the course of events are constantly shifting.

On-the-ground fundamentals

In short, the market is flying blind. But traders make decisions and take positions in the vast derivatives market, to hedge or speculate. Large speculative bets placed – and reversed -- on hunches amplify price swings and can push even the median price further out of line with on-the-ground fundamentals.

Asymmetric information flows and inherent biases in the media with first-hand access to critical information can worsen the signal-to-noise ratio, while an escalating cycle of rhetoric exchanged by the opposing sides takes on a life of its own. Rumours, unconfirmed or distorted “reports”, speculation and conspiracy theories in social media can create a din of confusion that compounds the already high levels of uncertainty.

Volatile band for ICE Brent futures

Little wonder, then, that ICE Brent futures swung within a volatile $8/barrel band on the first two trading days of the Israel and Iran exchanging fire – scaling a high of over $78 and scraping the bottom around $71.

That prices pulled back from intraday peaks on both days to settle nearer the bottom end of the day’s trading range -- and have not threatened to spike towards the psychological $100 mark -- offers little comfort to the companies across downstream sectors whose energy input costs have already spiked.

Calm before the storm

Brent’s five-month high settlement of $76.45 on June 17, after US President Donald Trump upped the ante by demanding an “unconditional surrender” from Iran and threatened to strike the Islamic Republic, mark a 17% jump over the April 1-June 12 average, when prices had hovered in narrow band with an eye on the US tariff wars. The stability in the crude market through April and May turned out to be the calm before the storm.

Crude’s volatile swings in such geopolitical storms typically benefit only speculative traders, provided they are able to buy and sell derivatives contracts at just the right time. For the vast majority of companies at the receiving end of the unanticipated crude spikes – or price-takers as they are called – there is usually no cover.

While there are is much speculation around the potential “worst-case” scenarios that could trigger an oil supply shock and send crude soaring into triple digits – including a blockade of the Strait of Hormuz or aerial strikes crippling oil fields and related infrastructure in the region – the market has so far assigned a low probability to such outcomes.

Impact of GPS signal jamming

However, a worrying spike in GPS signal jamming affecting ships in and around the Strait – allegedly emanating from the Iranian port of Bandar Abbas – raises the risk of disrupted traffic even in the absence of a formal blockade.

Oil production in the Middle East, including Iran, amounts to around 25 million b/d, nearly a quarter of the global consumption. The Strait of Hormuz, a narrow waterway between Iran and Oman, provides transit to about 20 million barrels of crude and refined products on a daily basis.

No halt in productions

So far, the latest burst of Israel-Iran war has not halted production in the region or supply to the global markets. The Strait of Hormuz remains open to shipping, though a war risk premium has pushed up freight and insurance rates for vessels in the region.

The idea of Iran or Israel intentionally jeopardising oil supply from the region is inconceivable, the rational mind says. But it is not impossible. There is always the risk of an accidental hit to a facility in a third country, which could also spark off a wider regional conflagration. When Israel and Iran exchanged aerial strikes in April and October last year, they were relatively restrained, limiting the damage caused to each other. But there is no certainty that they will play by the same rulebook.

Spare production capacity

The OPEC/non-OPEC alliance has spare production capacity estimated at a substantial 5-6 million b/d. But most of it is in the Middle East and wouldn’t be of much help if flows from the region get blocked. The International Energy Agency has said its member states stand ready to release 1.2 billion barrels of oil from emergency stockpiles and another 580 million barrels held in industry stocks in the event of a major supply shock. But any such release is a stop-gap solution whose effectiveness hinges on a quick elimination of the supply shock.

Even if the Israel-Iran tensions ease in the coming days, the latest crisis will end up taking heavy toll. A ceasefire, at best, would be tentative – a band-aid on a gunshot wound – given the deep historical roots of hostility between the two nations and markets could remain on tenterhooks for an extended period of time, potentially leaving a modest risk premium embedded in crude.

Monitoring inflation trends

Even if crude prices return to pre-war levels in a few weeks, consumers will end up paying higher prices on average for the duration of the conflict, footing the bill for “fear” even when the market was adequately supplied. For central banks closely monitoring inflation trends to chart a course on monetary easing, the episode will skew the picture.

All hopes are now pinned on President Trump to defuse the situation. The US President may be planning to lean on a weakened Iran to agree a nuclear deal on his terms. If an agreement does take shape, how well it will hold up, especially in the absence of a more lasting solution to the enmity with Israel sharpened by a festering Gaza war is anybody’s guess.

An increasingly fractured and fragmented world needs statesmanship, not opportunism. Until one appears, the energy markets – and the world – remain hostage to high-stakes uncertainty.