Our central scenario is that a major escalation of tensions in the region and a sustained increase in oil prices are unlikely.
Tensions between Israel and Iran have been escalating over recent weeks. Against a backdrop of robust global demand and OPEC+ output cuts, these heightened tensions have applied further upward pressure to oil prices, with Brent crude prices breaking above $90 per barrel for the first time since October 2023.
Scenarios and implications for oil markets
Our central scenario is that a major escalation of tensions in the region and a sustained increase in oil prices are unlikely.
First, Iran’s oil production is approximately 3 million barrels per day (Mb/d), or around 4% of the global total. If, for any reason, Iranian oil exports were disrupted, capacity exists to offset this loss. OPEC’s current spare capacity stands at around 4 Mb/d, of which 3 Mb/d sits with Saudi Arabia (the swing producer in global oil markets).
While many OPEC producers do benefit from rising oil prices, they are also mindful of the global economic stress caused by higher prices, as well as the prospect of a meaningful fall in prices in a global recession.
Second, there are other reasons why regional players have an interest in keeping the conflict contained. The Gulf states are in the process of transforming their economies away from a reliance on oil, and this transformation requires a sustained absence of hostilities in the region.
The Gulf states’ relations with Israel have improved since previous episodes of conflict in the Middle East. Israel now has long-standing diplomatic agreements with Egypt and Jordan, and normalised relations with the UAE, Bahrain and Morocco in 2020. Saudi Arabia was also considering formal ties with Israel last summer, though no further progress has since been made. Saudi Arabia and Jordan aided Israel in neutralising a recent Iranian attack.
Any escalation involving a closure of the Strait of Hormuz would likely lead to a more problematic increase in the global oil price, given 30% of the world’s seaborne oil trade passes through the strait. Indeed, all shipping traffic from the Gulf countries pass through Hormuz – including crude oil, oil products and liquefied natural gas exports from Iran itself.
However, this is not our central scenario. A closure of the strait by Iran would threaten its relations with China which, given current Western sanctions on Iran, buys the overwhelming majority of Iranian oil exports. In fact, all Iran’s oil exports are transported via the sea, so its own trade depends heavily on the free passage of goods and vessels through the seaway. Any move to block the strait would damage Iran’s own economy and also likely antagonise its Gulf neighbours. It is also worth noting that despite several threats of closure over the past few decades, the Strait of Hormuz has never actually been blocked.
Implications for global growth, inflation and interest rates
Amid generally sticky developed world inflation prints in recent months, markets have been considering what the prospect of higher oil prices might mean for interest rates and the broader economy.
How central banks respond to cost shocks, such as a rise in oil prices, depends on the state of the economy. If the economy is weak and running below capacity, cost shocks can depress consumption and lead to further weakness in activity. In this case, cost shocks can prompt monetary easing to avoid deflationary pressures emerging.
But when economies are strong, with low unemployment and little spare capacity, cost shocks can generate increased wage demands and sustained inflationary pressures. In this scenario, monetary policy is more likely to be tightened or kept restrictive to limit further price rises.
We view today’s economic picture as more similar to the latter scenario, with US growth resilient and labour markets tight across the developed world. Thus, we see any sustained increase in the oil price as likely to add to inflation stickiness, and therefore to modestly delay the speed of monetary easing from currently tight levels.
However, our expectation based on the current situation is that the oil price impact of recent Middle East tensions is likely to be fairly contained. We would therefore expect these tensions to dent, rather than derail, the broader ‘recovery’ narrative.