War premium boosts oil by more than 5%

Iran’s missile attack on Israel restored a war premium to oil markets as the prospect of military escalation between the two Middle East foes calls into question vital flows from the world’s top petroleum-producing region. 

Brent crude surged more than 5% following the assault Tuesday, exposing speculators who had been more bearish than ever in the weeks before the barrage. Oil rose again Wednesday to trade above $75 a barrel, meaning it’s added about $5 in two days. Benjamin Netanyahu, Israel’s prime minister, has vowed to retaliate to the attack, creating the risk of tit-for-tat escalation in part of the world that’s responsible for a third of the world’s supply.

Still, analysts and traders say the market hasn’t fully priced in the risk of a further attacks on Iranian oil facilities, or the idea that Tehran might try to block the Strait of Hormuz — something it’s threatened many times down the years without actually doing so. While numerous recent conflicts and confrontations haven’t ultimately resulted in oil-supply disruption, focus is now shifting to Israel’s next move. 

“No one really knows how far this could spread,” Trafigura Group’s chief economist Saad Rahim said in a Bloomberg TV interview. “What is the reaction now from Israel, what is the counter reaction then from Iran, do other players start to get involved?”

The latest developments come after money managers and hedge funds held the most bearish stance on oil on record late last month amid a backdrop of demand concerns and supply surplus. OPEC+ is poised to restore more output from December, while drillers outside the alliance are also ramping up production, leaving the market with plenty of wiggle room before running short of barrels — although much of that buffer is located in the Middle East. 

“The crude market was extremely short and complacent about geopolitical risk,” said Bob McNally, president of Rapidan Energy Group and an adviser in the George W. Bush administration. “The crude risk premium would only rise if the market saw an escalation that directly impacted energy infrastructure or flows, or if Israel attacked regime-threatening critical infrastructure.”

As prices rallied on Tuesday, significant moves in options markets showed traders scrambling to hedge against further gains. Volatility on US crude futures soared to an 11-month high, while there was — briefly — a small and rare premium for bullish calls over equivalent bearish contracts early on Wednesday. 

The strike by Iran, which produces more than 3 million barrels a day of oil, was a reprisal after Israel carried out a series of attacks on Lebanon in recent days. The OPEC producer had also threatened to retaliate after the political leader of Hamas was killed in Tehran in July — an attack blamed on Israel.

Oil could climb as much as $7 a barrel if the US and its allies placed economic sanctions on Iran, or by $13 should Israel strike Iranian energy infrastructure, according to preliminary estimates from Clearview Energy Partners. The firm said the biggest impact would be a disruption to flows through the Strait of Hormuz, which could drive crude $13 to $28 higher.

The Strait of Hormuz is a narrow waterway at the mouth of the Persian Gulf through which almost all the region’s oil must flow if it is to reach global markets. Its shallow depth make ships vulnerable to mines, and its close proximity to Iran leaves tankers open to attack from missiles or interception by patrol boats. Iran-backed Houthi militants have been carrying out similar measures against commercial ships sailing through the Red Sea.

“While Israel may have a superior advantage militarily, Iran may utilize its geographical advantage to disrupt the key shipping route at the Strait of Hormuz,” said Yeap Jun Rong, a market strategist for IG Asia Pte in Singapore. “In this case, oil prices will surge.”

OIL RESERVES

In the event of major and prolonged disruptions in the Middle East, the US is likely to tap its strategic petroleum reserve, according to traders and analysts. The stockpile currently holds about 383 million barrels, which provides a significant buffer.

As geopolitical risk premiums return, the increased involvement of algorithm-driven traders has added a further layer of uncertainty that may add to price swings.

Commodity trading advisers have grown into a formidable presence in oil markets in recent years, and their trend-following trading style often amplifies price moves in both directions, making it harder for traders with physical exposure to navigate the market.

“The market is likely to remain jumpy for now on the what-if, particularly while it awaits Israel’s retaliations and those with short positions buy into any dips to exit their positions to avoid the risk of being caught by another leg higher,” said Callum Macpherson, head of commodities at Investec Plc. “There might not ultimately be any disruption to supply though.”