Commentary

A Week of Consequence: Oil Markets Complacent but on Edge following Turmoil in Iran and Iraq

January 7, 2020

One week ago, as President Trump prepared to usher in 2020 at his resort in Mar-a-Lago, he met with members of the press, predicting a “fantastic year” for the United States and entertaining questions about the embassy compound demonstrations in Baghdad and the evolving situation in Iran. He said he wanted peace with Iran and noted he had spoken with Iraq’s prime minister and had thanked the Iraqi government for its support in helping defuse the embassy protests. As the year closed, oil prices were already being buoyed by bullish bets on tightening supply, more positive projections of demand related to Trump’s announcement of a phase one mini-deal with China, and ongoing violence in Iraq. (On December 27, the terrorist group Kata’ib Hezbollah attacked a military installation outside of Kirkuk, killing an American contractor. On New Year’s Eve, protesters and militia stormed the U.S. embassy compound.)

Last Friday, oil prices spiked to their highest levels in a month (with Brent approaching $70 per barrel) following news that a U.S. drone strike had killed both General Qasem Soleimani, head of the Islamic Revolutionary Guard’s Quds Force and Iran’s top military commander, and Abu Mahdi al-Muhandis, the founder of Kata’ib Hezbollah and deputy commander of Iraq’s Popular Mobilization Forces. In short order, Iran’s supreme leader vowed “forceful revenge” on the United States while President Trump responded with the threat of a disproportionate response that would devastate Iran.

Over the weekend, Iran announced that the country’s nuclear program would no longer face R&D or enrichment restrictions pursuant to the Joint Comprehensive Plan of Action (JCPOA)—presumably to force action from the European Union related to aid and sanctions relief. In Iraq, the parliament adopted a non-binding resolution calling for the eviction of foreign forces from the country. Press reports indicate that the legislative body had barely managed to assemble a working quorum (52 percent) and that Kurdish and Sunni members were largely absent, although reports also indicate popular support for evicting U.S. forces, especially among the Iraqi Shia population. In reply, President Trump has threatened the imposition of crippling sanctions on Iraq.

As markets opened this morning, the combination of Asian unease about future oil supplies and short covering on the part of traders and investors kept oil in the $68-69 per barrel range. The expiration of the February futures contracts last week prompted traders to cover their outstanding call options as prices rose. Speculative investors reacted to what they saw as greater upside risk and opportunity for profit over the next several weeks due to both potential physical tightness in the market and heightened geopolitical risk. Asian buyers in particular, notably Japan, China, South Korea, and India, remain increasingly vulnerable to oil price shocks and reliant on Middle East sources despite increased efforts at supply diversification.

The prospect of Iranian strikes (directly or through proxies) and the potential for diminishing U.S. diplomatic and military presence in the region carry serious implications for future stability and threats to allies. Yet oil market watchers are currently fixated on near-term price movements and profit taking opportunities (including hedging for U.S. producers) while watching for signs of impending disruptive events. Speculative commentary now abounds with respect to the form and severity of further escalation and potential retaliatory strikes. As evidenced by this morning’s opening (Brent has retreated below $68.50 per barrel), however, markets remain eerily complacent even as concerns in Libya and Venezuela build alongside the Middle East tensions.

And while there is currently ample spare capacity in the world, the bulk of it resides in the troubled Middle East. Policymakers may be poised to access strategic petroleum stockpiles, but history shows such releases are often slow and unable to offset major disruptions. The uncertainty surrounding the timing, targets, and duration of any supply disruptions linked to an Iranian (or U.S.) retaliation is likely to keep oil markets on edge for weeks to come—at least until a path forward becomes clearer. While the paper markets for oil are often susceptible to headline reactions, tend to become highly leveraged, and typically overreact to events, nothing has changed in the physical market to date. The Middle East still counts. Markets may yet be underestimating the full import of the recent escalation in terms of pricing in prospective risk, but only time will tell if that assessment is correct.

Frank Verrastro is a senior vice president and trustee fellow with the Energy and National Security Program at the Center for Strategic and International Studies (CSIS) in Washington, D.C. Albert Helmig and Larry Goldstein are non-resident senior associates with the CSIS Energy and National Security Program.

Commentary is produced by the Center for Strategic and International Studies (CSIS), a private, tax-exempt institution focusing on international public policy issues. Its research is nonpartisan and nonproprietary. CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author(s).

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