• Middle East conflict rattles investor confidence

• Markets tread cautiously on Middle East woes

• Tension in the Middle East poses one of the most significant geopolitical risks to oil markets since Russia's invasion of Ukraine: How has OPEC reacted

• Will global oil prices keep rising?

As geopolitical tensions rise, the financial markets are inundated with heightened volatility and uncertainty. A heightened sense of caution infuses the investment community due to the intensifying conflict between Israel and Hamas in the Gaza strip, fuelling concerns of possible escalation. This global unease has propelled crude oil, pushing the brent oil surpassed USD90 level.

One of the rules of thumb of geopolitics is that recessions are sparked by a sharp jump in oil prices, and the cost of crude oil is sensitive to events in the Middle East.

Oil still matters: which is why strife in the Middle East are being so carefully monitored

The current tension in the Middle East poses one of the most significant geopolitical risks to oil markets since Russia's invasion of Ukraine last year. While oil flows have not yet been affected, we could look to two scenarios.

The first scenario - and the best-case one for the global economy - is that the war is contained to an Israeli ground assault on Gaza Strip. In those circumstances, oil prices would stabilise and could soon start to fall back. Russia’s invasion of Ukraine in 2022 caused major commodity markets to fragment, and continued geopolitical tensions could make matters worse. Study by the IMF finds that commodity markets are particularly vulnerable in the event of fragmentation. Further fragmentation of commodity could cause large price changes and more price volatility. The IMF estimates that a sustained 10% increase in oil prices shaves 0.15 percentage points off global economic growth and adds 0.4 points to inflation in the following year. On the world’s commodity markets, the cost of a barrel of crude is now about 10% higher than it was before the Hamas attack.

The second scenario involves a broader regional conflict, starting with fighting on Israel’s northern border with Iranian-backed Hezbollah forces in Lebanon, but eventually dragging Iran into the conflict. The arrival of US carrier groups in the eastern Mediterranean suggests Washington is making contingencies for this. If Iran were drawn into the war this would create major global risks by disrupting energy supplies and pushing up oil prices. A broader regional conflict in which Lebanon, Egypt and Syria, as well as other Arab states became embroiled and in those circumstances the oil price could approach and break USD100 a barrel, sending inflation back into double digits especially in the US and Europe. Consequently, the threat of global recession would prompt central banks to cut interest rates and restart quantitative easing programs.

How has the oil market reacted so far?

The knee-jerk reaction to the most recent escalation has been a 5% jump in Brent prices on 9 October to USD88.15 a barrel. Similarly, West Texas Intermediate (WTI) crude oil, jumped 4.2% to USD86.38 a barrel. The prices had risen more than 1% for a second consecutive weekly jump on fears of potential supply disruption if the Israel-Hamas war grows into a wider confrontation in the Middle East, the world's biggest oil-supplying region. Brent crude oil reached a new recent high of USD93.79 whilst WTI reached high of USD94.00 before easing back slightly.

Oil prices fell more than 2% on 23 October as concerns about supply disruptions eased due to diplomatic efforts intensifying in an attempt to contain the conflict between Israel and the Palestinian Islamist group Hamas. Brent crude oil fell 2.53% to USD89.83 a barrel and WTI crude oil were down 0.58% at USD85.99 a barrel. The current cautious trading sentiment should persist as investors keep an eye on the ongoing geopolitical developments in the Middle East as well as the interest rate outlook from global central bankers. The scale, intensity, duration, and breadth of the ongoing situation will be important factors in determining the impact on oil prices in the coming months.

Markets tread cautiously on Middle East woes

The risk of a wider conflict in the Middle East clouded sentiment. Israel has stepped up air raids on Gaza in preparation for the “next phase” of its conflict with Hamas, while also warning that Hezbollah risks dragging Lebanon into a wider regional war. Washington also warned over the weekend of a significant risk to US interests in the region as ally Israel pounded Gaza and clashes on its border with Lebanon intensified.

As reported, Israel bombarded Gaza with more air strikes on Monday (23 Oct) as its soldiers fought Hamas militants on the ground in raids within the besieged Palestinian enclave. In signs that the conflict was spreading, Israeli aircraft also struck southern Lebanon overnight and Israeli troops fought Palestinians in the occupied West Bank. According to Reuter’s news, Iranian security officials told Reuters that Iran's strategy was for Middle East proxies like Hezbollah to pursue limited strikes on Israeli and US targets but to avoid a major escalation that would draw in Tehran.

In the currency market, moves in the foreign exchange market were largely muted and the overall momentum in the currency arena seems relatively restrained. The USD lost as the US Treasury yields declined. The dollar index (DXY), which measures the greenback against six major peers, fell 0.6% at 105.54. Despite the weakening positive correlation between the UST yields and USD of late, the fall in the UST yields definitely contributed to the USD depreciation. The yield on the benchmark 10-year US Treasury note rose above 5.0% on October 23, hitting the July 2007 milestone that it briefly attempted to scale last week. The yield on 10-year US Treasury bond reached 5.021%, before it later retreated and closed at 4.85%. The run-up in yields on the 10-year Treasury bond which was seen as a safe-haven in times of economic uncertainty and a benchmark for borrowing costs around the world, has been driven by investors pricing in stronger US growth. Falling US Treasury yields left markets betting on lower odds of a hike by the Federal Reserve and had the USD losing interest. The Malaysian Ringgit fell 0.6% as USDMYR was seen trading near the 4.80 handle. As of writing, the USD/MYR pair was seen trading around 4.7837 as it was only slightly lower than previous day’s levels amid the decline in UST yields. We stay wary of further upside for the USD/MYR given it is still uncertain whether UST yields have peaked. Malaysia rates have been lagging well behind the US given that BNM has not hiked as much as the Fed. As it stands, the last statement from BNM at the last monetary policy meeting did not hint at any further hike.

Risk sentiment improved early this week compared to Friday as tensions in the Middle East did not escalate as much as feared during the weekend. Following a robust rally last week, Gold appears to be taking a breather, moving into a consolidation phase and seems to be encountering resistance around the much-watched USD2,000 psychological mark.

The market has been reacting to the news mainly by seeking safety in gold. Gold spiked to USD1,997 per ounce on 20 October on fears that tensions would further escalate in the Middle East. As the weekend news was somehow better, gold eased to USD1,964 on 23 October. Still, upside prevails and the next wave of haven flows will likely push gold prices above the USD2,000 mark. Above that level, we enter a little-known region. The price of an ounce reached USD2,075 in August 2020, tested USD2,070 in March 2022 at the wake of the beginning of the Ukrainian war, and the Gold traded at USD2,081 in May, this year. The war in Gaza throws the foundation for a fresh attempt to a new high above USD2,080. Note, however, that as soon as tensions in the Middle East stabilize, gold will come under a decent selling pressure as the US 10-year yield flirts with the 5% level.

Tension in the Middle East poses one of the most significant geopolitical risks to oil markets since Russia's invasion of Ukraine: How has OPEC reacted

Ministers from the Organization of the Petroleum Exporting Countries (OPEC) and allies led by Russia, (OPEC+) that met on 4 October made no changes to the group's oil output policy, after Saudi Arabia and Russia said they would keep voluntary supply cuts in place to support the market. Saudi Arabia said it would continue with a voluntary cut of 1 million barrels per day (bpd) until the end of 2023, while Russia said it would keep a 300,000 bpd voluntary export curb until the end of December. Following this announcement, oil prices continued to decline until the attack in Israel reversed the trend. The fear driving oil prices is the potential for escalation.

OPEC had sidestepped calls by Iran for an oil embargo against Israel October 18 after regional tensions were stoked further following the explosion at a Gaza hospital. Iran's foreign minister, as cited by Iran's official IRNA news agency said that "Islamic countries that have diplomatic relations with the Zionist regime [should] cut their relations with that counterfeit regime immediately, expel the Zionist regime's ambassadors from their countries and stop any oil exports to that regime”. However, an OPEC delegate said that "We are not a political organization" and the group had not discussed an oil embargo on Israel. Meanwhile, an Algerian OPEC delegate said the possibility of an oil embargo did not concern them "because we do not sell them [Israel] any oil or gas. We do not have diplomatic and commercial relations with them. The question may arise for other questions but not for us". OPEC+ does not make knee-jerk reactions to market challenges and Russian Deputy Prime Minister said that current oil prices factored in the conflict and reflected the market's belief that risks posed by the clashes were not that high.

The Middle East conflict had not had a direct impact on oil supplies and fundamentals would remain a bigger driver of prices. Oil prices would be unlikely to rise substantially unless there is disruption in the Strait of Hormuz. The Strait of Hormuz, located between Oman and Iran, connects the Persian Gulf with the Gulf of Oman and the Arabian Sea. The Strait of Hormuz is the world's most important oil chokepoint - narrow channels along widely used global sea routes that are critical to global energy security - because of the large volumes of oil that flow through the strait.

Will global oil prices keep rising?

The global oil supply would likely tighten if Iran’s oil production drops again. Despite US sanctions, Iranian crude exports have grown significantly this year. OPEC, on September 12, announced that Iran has regained its position as the third-largest crude oil producer, with a production of 3mn barrel per day in August, offsetting some of Riyadh and Moscow's 1.3 million barrel per day voluntary cut. The Iranian production increase has also been facilitated by a relaxation of US sanctions. The question now is whether the US would impose new sanctions on Iran if evidence emerged that Iran was involved in Hamas’s surprise attack on Israel. Tighter US sanctions on Tehran would threaten crude supplies and push up oil prices globally.

So far, we have seen some volatility in oil prices since the tension exploded between Israel and Hamas amid speculation about how the conflict could affect oil production in the Middle East. Israel nor the Palestine are significant oil producers, but markets have been jolted by fears that the conflict could lead to wider regional instability. The Middle East is home to some of the world’s biggest major oil producers, including Iran and Saudi Arabia, as well as key transit routes such as the Strait of Hormuz, which is known as the world’s most important “oil chokepoint”.

While much will depend on how the conflict plays out, the immediate effect on oil prices is likely to be limited. The current struggle in the Middle East does not directly involve oilproducing nations, unlike the spike in oil prices that followed Russia’s invasion of Ukraine last year. Therefore, the near-term risk to oil supply was low but that could change if the conflict spread to other countries. The recent jump in oil price reflects the oil market being concerned about the conflict becoming a wider conflict, which could involve Middle East regional players becoming involved through their proxy agents.

Significantly, the world is watching out in close attention for the responses of the OPEC. We believe that the impact on oil prices and the resultant OPEC response would depend on the scale and reach that the conflict takes. If it remains localised without affecting major oil producers or transit routes, prices may see limited immediate change, prompting OPEC to maintain current production levels. However, if it escalates and involves the region but without direct impact on major oil sources or routes, there may be speculative shifts in the oil market, and this could lead OPEC to consider production increases for price stability. Oil supply could face a significant risk if the conflict spreads to other countries or affects important passages like the Strait of Hormuz. This would require OPEC to increase production or work with non-OPEC oil producers to maintain market stability. If the conflict escalates to involve Iran, OPEC interventions will become more critical as this could also be accompanied by stricter US sanctions on Iranian oil exports.

It is difficult to tell how events will unfold in the months to come, but the conflict could easily spread to neighbouring states. Therefore, a key issue to watch in the weeks and months to come is whether there will be disrupted oil supplies from Iran or whether a sustained oil price increase will alter Saudi Arabia’s plans to unwind its production cuts.

Source: BIMB Securities Research - 25 Oct 2023