Since the Hamas attacks on Israeli citizens on October 7, the oil market has seemingly shrugged off escalation risks. Despite the brutal assault on Gaza that has killed an estimated 33,000 Palestinians, disruptions to shipping lanes due to frequent attacks on Red Sea vessels by Houthi militants, and low-level conflict between Israel and Hezbollah, the market response has been muted. This is largely because disruptions to physical supplies of crude oil and product products have not materialized. Instead, macroeconomic concerns have continued to drive sentiment in an oil market that has remained well supplied, with production cuts by the Organization of the Petroleum Exporting Countries and allied producers (OPEC+) last year offset by supply growth elsewhere.
Recent price increases suggest that market sentiment is changing, with Brent crude oil climbing above $90 per barrel in early April. With traders now anticipating tighter crude and product fundamentals for the rest of the year, markets are now more sensitive to the risk of potential geopolitical disruptions to supply. The possibility of a direct confrontation between Israel and Iran that could disrupt flows in the Persian Gulf looms especially large. An overt Iranian retaliation for the recent Israeli airstrike in Syria that killed a senior Islamic Republican Guard Corps commander could ratchet up prices toward $100 per barrel.
Signal, Not Just Noise
Market fundamentals should continue to underpin higher oil prices through the remainder of the year. Oil demand growth in the first quarter was relatively strong, including U.S. transportation demand, and the International Energy Agency (IEA) recently upgraded its first quarter demand growth figure to 1.7 million barrels per day (b/d). The agency has raised its 2024 demand forecast to 1.3 million b/d—far lower than last year’s 2.3 million b/d, but still strong by historical standards. Asia will be the key engine of growth. China’s demand growth is widely expected to slow this year after an exceptionally strong 2023 as post-Covid travel subsides and its economy slows, but Chinese petrochemicals demand remains robust. And both India and the Middle East will support demand.
Meanwhile, on the supply side, deep cuts from OPEC+ have driven Brent crude futures into steeper backwardation (with prices for prompt delivery exceeding those for future delivery) on the back of expected OECD stock draws for the remainder of the year. The group’s continued commitment to short-term market management should give it the upper hand in keeping prices in their current range. In March, OPEC+ extended existing production cuts until the end of June (including a 1 million b/d unilateral Saudi cut and a revised schedule for Russian crude oil production and exports). The group’s propensity to be proactive on the downside and reactive on the upside will encourage continued caution, possibly encouraging it to extend its cuts into the second half to stabilize prices at their current $90 per barrel level. Non-OPEC supply growth will remain robust, but manageable from an OPEC+ perspective. And many forecasters expect that U.S. shale production growth will finally slow this year. Less exuberance from private players, consolidation in the shale patch, a falling number of drilled but uncompleted wells, and continued capital discipline suggest less upside. Shale producers continually surprise the market, and growth in the past few years has consistently surpassed expectations. But the U.S. Energy Information Administration (EIA) expects U.S. crude oil production to rise this year by 260,000 b/d—well below last year’s growth rate.
Geopolitical Risks Harder to Ignore
With fundamentals strong and inventories lean, markets will remain wary of geopolitical risks to supply, as the price rise over the past two weeks has illustrated. The volatility that characterized markets last year is also likely to return, as paper traders pay greater attention to geopolitical events. The threat of escalation has been a concern for markets since October, especially any signs that the war was extending to Iran. A wider war between Israel and Hezbollah that could drag Iran more directly into the ongoing conflict could be one catalyst for escalation. Thus far, all-out conflict on Israel’s northern border has not materialized, despite thousands of cross-border rocket and missile attacks since October and recent Israeli strikes deeper into Lebanese territory. Hezbollah’s aversion to a potential political backlash if it drags Lebanon into war, as well as U.S. pressure on Israel, have probably helped to keep the conflict from widening.
Recent events suggest it will become harder to contain such risks. An April 1 airstrike on Iran’s embassy compound in Damascus killed seven members of Iran’s Revolutionary Guards, including a senior Quds Force commander who previously led operations in Syria and Lebanon. The United States and Israel are preparing for Iranian attacks on their assets in the region. Yet Iran will probably be wary of actions that will drag it into a direct confrontation with Israel or the United States, and past experience shows that a spectacular immediate response is not the likeliest outcome.
Iran may instead opt for “strategic patience” and a response that leverages its proxy forces and allied militias throughout the region. When the United States killed General Qassem Soleimani in a January 2020 drone strike, Iran responded by launching missiles at U.S. bases in Iraq that did relatively little damage, and it refrained from a wider immediate assault. In the past week, Iran’s president and Hezbollah’s leader have vowed to respond to the Israeli strike. But such a response may again feature symbolic attacks meant to signal Iranian resistance and defense of its interests, rather than a more brazen approach such as a Hezbollah rocket assault on Israel. The past few months have shown that Iran’s “axis of resistance” enables it to cause trouble throughout the region. Iran could encourage missile or drone attacks on U.S. troops in Iraq and Syria, scale up tanker attacks and sabotage in the Persian Gulf (Iran maintained plausible deniability for a series of such attacks in 2019), and increase its support for the Houthis. It is also possible that Iran could lash out against U.S. or Israeli interests outside the Middle East. These actions would be in keeping with Iran’s reliance “on the diversity and dispersion of its tools to make its adversaries reluctant to respond directly.”
Beyond the immediate threat of Iranian retaliation, there is a long-term risk associated with domestic political dynamics in Israel. Prime Minister Benjamin Netanyahu remains a particular wild card. His domestic popularity is sinking, and he faces the possibility of prosecution if he is removed from office, so Netanyahu has personal political incentives to extend the war, not just in time but also in scope. Israel’s recent strike in Damascus was part of an ongoing shadow war with Iran, but it also appeared designed to goad Tehran into more open retaliation. Escalation, even just against Hezbollah, would stretch the Israel Defense Forces operationally. Nevertheless, it would reinforce Netanyahu’s claims that Iran remains an existential threat to Israel that must be countered.
There are several important implications for the oil market. The biggest risk is that escalation draws Israel and Iran into more direct confrontation, which would put Iranian production at risk and raise the possibility that Iran could disrupt the 18 million b/d of oil flows through the Persian Gulf. Unlike the Red Sea, there are no alternative routes for Gulf shipping. If any such disruptions materialized, their impact on prices would be seismic given the volumes at risk. But even a heightened sense of threat will add a geopolitical premium to prices given current and anticipated fundamentals.
These risks could ramp up just as the market is expected to tighten in the second and third quarter and the summer driving season begins in the United States. An oil price of $90 per barrel is no doubt causing anxiety in the Biden administration, which recently canceled its latest solicitation to help refill the Strategic Petroleum Reserve (SPR) due to higher prices. The Department of Energy has been gradually refilling the SPR, which now sits at 364 million barrels. If market risks accumulate and prices inch toward or above $100 per barrel, several options will be on the table for the White House, potentially including a shift from SPR refills to releases and renewed exhortations for OPEC+ to add barrels into the market.
This trajectory is not inevitable. Ultimately, the fundamentals win. It is quite possible that supply risks—especially the most apocalyptic—will not materialize, and the current bullishness will fade. But market psychology has shifted significantly, and it tends to take on a momentum of its own in the absence of clear evidence to the contrary. At a minimum, prices are likely to stay at their current level, and, as long as the conflict in the Middle East continues, volatility seems likely to return.
Ben Cahill is a senior fellow with the Energy Security and Climate Change Program at the Center for Strategic and International Studies (CSIS) in Washington, D.C. Raad Alkadiri is a senior associate (non-resident) with the Energy Security and Climate Change Program at CSIS.
