Global markets breathed a sigh of relief this week after the US and Iran pulled back from the brink of what had the makings of a major armed conflict.
While oil prices whipsawed from US$70 to $65 on the escalation and de-escalation respectively, investors remain on guard for a resumption of tensions and possible disruptions to the Middle East region’s energy exports.
Industry observers say they are weighing various “bad” case scenarios, particularly possible future disruptions to oil shipments through the Strait of Hormuz, each of which could cause a new spike in oil prices and impact global growth.
The risks, they say, are particularly acute among Asia’s net energy importers.
The main scenario sees Iran blocking the 39-kilometer-wide Strait of Hormuz, the world’s most important and vulnerable oil transit choke point lying between the Gulf of Oman and Persian Gulf, in retaliation for a new US strike or economic sanction.
In 2018, daily oil flows through the Strait of Hormuz averaged 21 million barrels per day, or the equivalent of about 21% of global petroleum liquids consumption, according to US Energy Information Administration, a US government statistical agency.
That year, flows through the strait represented about one-third of total global seaborne traded oil. More than one-quarter of global liquefied natural gas (LNG) trade also transited the Strait of Hormuz in 2018, with large shipments going to key Asian markets including China, Japan, India, South Korea and Taiwan.
For years, Iran has threatened to close this vital energy passageway, though it remains a matter of debate over whether Iran has the naval capacity to block, and keep blocked, the strait in any conflict scenario.
The Strait of Hormuz was a theater of conflict during the Iran-Iraq War in the 1980s, when each side tried to sink the other’s energy exports in what was later described as a “tanker war.”
To avoid being targeted in the conflict, Kuwaiti oil tankers were reflagged under the US shipping registry, obscuring their true ownership. Although crude oil shipments continued the strait during the war, marine vessel insurance rates plying the passageway spiked by as much as 400%.
More recently, in June 2018, Iran threatened to close the Strait of Hormuz to retaliate against the ratcheting up of US sanctions against its energy exports. Those disruptive concerns came to fruition last June, with attacks on Japanese and Norwegian-owned oil tankers traveling in the strait.
Iran, true to form, denied any involvement in the anonymous attacks, but the US later released video footage that apparently showed Iranian special forces removing an unexploded mine from one of the tanker’s hulls, indicating apparent Iranian sabotage.
Some analysts at the time believed that the attacks, including one while Japanese Prime Minister Shinzo Abe was in Teheran, sought to send a message to Tokyo that its vital oil and LNG shipments could be in jeopardy if its US ally did not pull back on sanctions.
The disruptive threat also no doubt reverberated in China, the world’s second largest LNG importer after Japan, which uses the super-cooled fuel mostly for its import-dependent power sector.
It’s unlikely, though, Iran would target Chinese shipments as one of the few countries that continues to import crude oil from the Islamic Republic, despite US sanctions on its exports.
However, if Iran or its proxies started to directly target US-flagged oil and gas ships, while allowing other tankers including those destined for China to pass, it could spark a wider geopolitical conflict that would inevitably lead to a sustained and potentially high rise in oil prices.
Under that extreme and perhaps still unlikely scenario, the US would likely be forced to respond militarily, with unpredictable blowback and impact on regional stability.
While it does not appear from military analysts’ assessments that Iran has the military muscle to enforce a blockade of the strait, it could still sporadically harass and seize select vessels, including from Asian nations allied with the US.
Such hypothetical sporadic attacks on tankers would likely impact global oil prices, including via the pass-through effect of higher insurance premiums on shipments that travel through the Strait of Hormuz.
Indeed, global oil prices rose in response to last June’s attacks on Japanese and Norwegian tankers, though not as much as some market analysts had expected.
Prices jumped around 4% but pulled back the same day on global economic growth worries over the ongoing US-China trade war and its negative impact on global oil demand. The day after the attacks oil prices traded flat.
Any further but limited actions by Iran in the Strait of Hormuz would likely see a brief impact on global oil prices, though that would of course depend on the scale and nature of the disruption.
It’s possible that Iran could target oil and gas shipments to US allies like Japan and South Korea to exert maximum political and diplomatic pressure.
Under this scenario, oil prices would spike while tensions unfolded, with some weighing the potential for Iranian insurgent-type attacks on US vessels deployed to restore freedom of navigation.
Both Japan and South Korea, however, would likely increase shipments from other suppliers, including Saudi Arabia and Russia – the world’s first and second largest oil exporters – in such a disruptive scenario. Indeed, targeting Japan and South Korea for a prolonged period would not likely be feasible for Iran.
That’s because the country still needs allies as it seeks to roll back the impact of US-led economic sanctions on not only its energy sector but other parts of its economy as well. US President Donald Trump has said he will impose new sanctions on Iran in the wake of their recent tit-for-tat drone and missile attacks.
One reason for the mainly muted response in global oil markets can be attributed to rising US oil production. US production now averages around 12 million barrels per day and is poised to start exporting significant amounts of energy.
That emerging dynamic not only acts as a buffer for US markets against oil price volatility caused by Middle Eastern events and instability, but also keeps a lid on global prices as the market responds to a supply overhang.
New attack on Saudi Arabia
Another scenario emanating from Iran would be a fresh attack on Saudi oil production infrastructure, similar to the surprise attack last September, with the possibility of sustained or repeated attacks including from Iranian proxy groups that operate outside of the country.
The total supply loss from taking facilities out of operation in September amounted to 5.7 million barrels per day, more than half of Saudi Arabia’s average output and around 6% of global supply. Two billion cubic feet per day of associated gas was also taken off-line.
A new Iran-led or proxy group attack on Saudi oil production could play out one of two ways. First, it could unfold in similar fashion as before with considerable saber-rattling but without a military response.
If the US and Saudi Arabia didn’t respond and the Saudis brought oil production back online quickly, as they did last year, oil prices would quickly stabilize as before.
However, if the US and Saudi Arabia retaliated militarily and a conflict situation spiraled, higher prices would impact global economic growth, adding downward pressure on Asian economies already hit by the US-China trade war.
China, Japan and South Korea would also be impacted under a worst case scenario of a sustained attack on Saudi oil production due to their high reliance on Middle Eastern crude.
Beijing, for its part, would likely have to step up its diplomacy. China’s imports of Saudi Arabian oil soared in the first 11 months of 2019, pushed up by several massive joint refinery projects.
China imported 8.2 million tons of crude oil from Saudi Arabia in November, which pushed the total volume in the first 11 months of the year to a record 76.3 million tons, up 53% from a year earlier, according to Chinese customs data.
That surpassed the 70.3 million tons of oil imported from Russia, and 47.1 million tons imported from Iraq.
Barring a major military confrontation between the US and Iran, or a major blockade of the Start of Hormuz, oil markets seem more prepared to roll with the punches nowadays than previously.
However, the current rapprochement between the US and Iran may not last long as the fundamental sources of the two sides’ conflict remain wholly unresolved, meaning the potential for more oil price volatility is always near.