Experts React: Energy Implications of Escalating Middle East Conflict

Commentary by Kevin Book, Ben Cahill, Adi Imsirovic, Raad Alkadiri, Kunro Irié, andLeslie Palti-Guzman

Published October 8, 2024

The escalating turmoil in the Middle East threatens to reshape global energy markets, yet oil prices remain curiously stable. What's behind this unexpected market calm in the face of growing regional conflict? The CSIS Energy Security and Climate Program turned to leading experts for insights. In the following essays, they delve into the factors keeping oil prices in check, discuss scenarios that could disrupt markets, and examine how the widening conflict might impact global liquified natural gas (LNG) supplies.

Supply Risk Rises Again| Kevin Book

Why the Market Is Still Not Panicking| Ben Cahill

Market Undercurrents Steering Oil Prices Amid Middle East Conflict| Adi Imsirovic

Middle East Escalation Reverses Oil Price Decline| Raad Alkadiri

Two Factors to Track for LNG| Kunro Irie

U.S. LNG Trade Will Suffer If Freedom of Navigation in the Red Sea Is Not Restored Soon| Leslie Palti-Guzman

Supply Risk Rises Again

Kevin Book, Senior Adviser (Non-resident), Energy Security and Climate Change Program

For months, oil markets did not seem to be pricing in the prospect that Israel's multifront battle against Iran and its regional proxies might disrupt global supplies. The front-month Brent crude futures price had fallen about 20 percent, from roughly $90 per barrel (bbl) when Tehran and Tel Aviv last confronted one another directly in mid-April, to a little less than $72/bbl at the end of September. Last week, however, Brent surged approximately 10 percent or a little more than $7/bbl, and on Monday it reached an intraday peak north of $81/bbl. Traders appeared to be factoring in strikes on Iranian petroleum infrastructure.

Even in an age of generative artificial intelligence, oil price estimates remain far from an exact science, and the impacts of supply disruptions can depend significantly on scope and duration. Back-of-the-envelope estimates by ClearView Energy Partners, LLC, gauged broad new sanctions (or strict enforcement of existing ones) at up to a roughly $7/bbl impact; attacks on Iran's principal export facility at Kharg Island at up to around $13/bbl; and a three-to-seven-day retaliatory Iranian blockade of the Strait of Hormuz between $13/bbl and $28/bbl.

Alternatively, Israel might opt to target the Islamic Republic's refinery capacity. In theory, doing so could curtail finished fuels within Iran without significantly diminishing global crude supplies, and Iran would temporarily return to its past reliance on refined products imports. However, Iran could still subsequently retaliate against regional transportation and production. And even if Israel and its allies successfully deflected most of last week's inbound projectiles, Arab Gulf producers are unlikely to have comparable defenses to shelter upstream, midstream, and downstream assets.

Israel could pick other targets. Secretary of State Antony Blinken assessed in July that Iran was only one or two weeks from a "breakout" toward a weapon. However, an Israeli strike against Iranian nuclear sites could lead to similar retaliatory consequences for regional production. Moreover, a significant Israeli response might lead Iran's ruling mullahs to conclude they cannot protect national security without a nuclear weapon. As such, escalatory prospects, and concomitant risks to regional production and transportation, could persist even if acute tensions recede.

Why the Market Is Still Not Panicking

Ben Cahill, Senior Associate (Non-resident), Energy Security and Climate Change Program

Last week's Iranian missile attacks-and muddled White House comments on potential Israeli strikes on Iranian oil infrastructure-produced the sharpest oil price rise in two years. Yet even in this febrile environment, the market is not panicking. Three factors help explain why.

First, this is a well-supplied market with a big buffer. The Organization of the Petroleum Exporting Countries and allied producers (OPEC+) has made several group-wide and voluntary production cuts in the past two years. But the group has struggled to bring those barrels back onto the market, thanks to a combination of weaker oil demand, especially in China, and robust non-OPEC+ supply. OPEC+ recently delayed a planned output increase for October until at least December, and 2025 does not look much better for market balances. As a result, the International Energy Agency estimates that OPEC+ has more than 5 million barrels per day (Mb/d) of spare capacity.

Second, the oil market no longer overreacts to potential supply risks. New intelligence tools including satellite surveillance and tanker trackers provide near-real-time data on loading, shipping, and inventory levels. These new resources have tempered price responses to potential supply disruptions. The September 2019 attack on the Abqaiq oil-processing facility and Khurais field in Saudi Arabia marked a turning point. Oil prices spiked after the attack, but because satellite surveillance proved that Saudi Aramco had repaired the damage to its facilities and used inventories to sustain export levels, within two weeks Brent crude prices were back at pre-attack levels. Traders have spent the last five years discounting oil supply threats in the absence of real disruptions.

Third, the geopolitical climate in the Gulf has changed. A China-brokered agreement between Iran and Saudi Arabia in 2023 showed a new desire to contain tensions. Trust between the parties is limited and Iran can still cause trouble in the region through proxy forces and acts of sabotage. But the Arab Gulf states are urging de-escalation, and it is now less likely that Iran would respond to an Israeli attack on its oil facilities by lashing out at its neighbors and wreaking havoc on oil exports. The often-mooted scenario of the closure of the Strait of Hormuz-home to about 30 percent of the world's seaborne oil transit-is overblown.

Naturally, the markets could be mistaken. A spectacular attack on Iran's refineries or oil terminals could shake off the market's complacency and send prices soaring. But if this doesn't happen, oil prices will likely decline as yet another bullish narrative fizzles out.

Market Undercurrents Steering Oil Prices Amid Middle East Conflict

Adi Imsirovic, Senior Associate (Non-resident), Energy Security and Climate Change Program

The recent escalation of conflict in the Middle East has sparked concerns over its potential impact on global oil prices. Some analysts argue that the market may be underestimating the geopolitical risks and the potential disruption to oil supplies, but the situation is more nuanced. The conflict in Palestine and Lebanon doesn't directly threaten oil supplies, as neither is a major producer. Any geopolitical risk would come from a prolonged conflict with Iran, which is one of the largest producers within the OPEC+ cartel at 4 Mb/d and about 1.3 Mb/d of exports, mainly to China.

Any Israeli attack on the oil export facilities would hurt not just Iran, but also global markets by increasing oil prices (or gasoline prices just a couple of weeks before the presidential election). If there was an Israeli attack on the Iranian energy sector, it would make far more sense to target refineries, hurting the Iranian economy and likely resulting in more Iranian oil exports.

With Brent below $80/bbl, the market is clearly not buying the worst-case scenario of a blockade of the Strait of Hormuz as a likely one. Other reasons for the relatively muted response to the geopolitical events are the prevailing fundamentals. Prior to the conflict, OPEC+ was struggling to prop up prices due to weak demand, especially from China, whose economic recovery has been slower than expected. Recent stimulus efforts in China seem aimed more at stabilizing the economy than boosting oil demand significantly.

Despite the cartel's efforts to paint a bullish picture, with forecasts for demand growth outpacing other industry estimates, its credibility has been weakened. It is likely that the oil demand is peaking this decade, while non-OPEC+ supplies can easily satisfy any potential increase in demand. Electric vehicles and the use of compressed natural gas have increased the demand response to higher oil prices. At the same time, the cartel has been cornered in its efforts to maximize short-term revenues as its production cuts have only incentivized the high-cost producers to add more oil to the market. OPEC+ still has an estimated 5 million b/d of excess production capacity, which it is eager to deploy to defend its market share if prices rise too sharply in the wake of a supply disruption.

Middle East Escalation Reverses Oil Price Decline

Raad Alkadiri, Senior Associate (Non-resident), Energy Security and Climate Change Program

Despite a roughly 10 percent rally in oil prices since Israel assassinated Hezbollah leader Hassan Nasrallah on September 30, short-term futures betray no sense of panic. Oil markets remain fundamentally bearish due to weak demand, non-OPEC+ supply growth, and the substantial spare capacity from OPEC+. But there is a political judgment here too.

This temperate reaction of oil prices to Middle East tensions betrays a sense that the current conflict can be contained. Washington's calls for Israeli restraint aside, Tehran has shown little appetite for escalating the conflict, or for locking horns directly with an increasingly belligerent Israel. Armed groups allied to Iran, including Hezbollah, have no doubt helped stoke regional violence, but the leaders of the Islamic Republic have largely sought to protect themselves, recognizing the potential threats to their own political survival of tangling with Israel. Unless Israel's reprisals significantly disrupt Iranian oil infrastructure, prices may again decline quickly, and even a loss of Iranian exports would likely cause only a temporary price spike given the OPEC's spare capacity.

Nevertheless, the war in the Middle East will continue to buffet oil prices over the next few weeks and months, with Israel's prosecution of the war a leading factor in future supply risk. Reeling from the murderous Hamas attack on October 7 last year, Israeli leaders increasingly look intent on destroying Gaza's erstwhile rulers and reshaping the long-term strategic balance of power in the Middle East in Israel's favor. The Biden administration has proven to be a feeble restraint on Israeli actions, and there is little to suggest that the next administration, whatever its hue, will intervene more forcefully. Meanwhile, domestic Israeli political dynamics, which have been much more of an influence on policymaking, do not point to greater Israeli caution in the short term.

Even if Israel is measured in its immediate next steps, and oil flows escape undisrupted, the risk of a wider-scale confrontation with Iran will persist if altering long-term regional power dynamics remains the Israeli agenda. At best, these conditions will add to short-term market volatility. At worst, they risk fueling an escalatory spiral that could eventually disrupt oil flows directly, whether from Iran or big Arab Gulf producers such as Saudi Arabia and the United Arab Emirates, and drive historic price increases.

Two Factors to Track for LNG

Kunro Irié, Visiting Fellow, Energy Security and Climate Change Program

While Iran is the world's third-largest producer of gas and has one of the largest global reserves, its current exports are limited to a very small amount via pipeline. Due to Western sanctions, Iran does not have any LNG exports and thus military conflict or attacks on its infrastructure pose little threat to global markets. But with tight global markets for LNG, in contrast to oil, the risks of supply disruption are still important. Two issues stand out.

First, the Hormuz Strait is a critical chokepoint for Middle Eastern exports of oil and gas to the global market. Qatar exports roughly 20 percent of global LNG through the Hormuz Strait and onward to Asia and Europe. The actual risk of a blockade appears low, but individual cargoes or ships could be affected by increased tensions and a full blockade would have large implications for prices.

Second, eastern Mediterranean gas fields, such as Tamar, Leviathan, and Karish, produce just over 20 billion cubic meters per year, supplying Israel and neighboring countries such as Egypt. Last year, the Israeli government temporarily halted production from those offshore assets after the October 7 Hamas attack. Risks from Hezbollah attacks seem low for now, but Iran has announced it could target Israel's offshore gas fields and energy infrastructure in an escalating conflict. A stoppage could mean an increased need for LNG for Egypt, adding to its planned winter cargo procurements, which could tighten the supply-demand balance going into the high-demand season. Even though European gas storage levels are at their highest level, a tight global market means this is a space to watch.

U.S. LNG Trade Will Suffer If Freedom of Navigation in the Red Sea Is Not Restored Soon

Leslie Palti-Guzman, Senior Associate (Non-resident), Energy Security and Climate Change Program

The Houthis have already attacked roughly 80 vessels in the Red Sea this year. The West has adopted a defensive approach, to avoid a greater regional escalation in the Middle East. As a result, no LNG tankers have used the Red Sea route (except for two Russian-affiliated LNG tankers) since mid-January. The longer the Bab el-Mandeb Strait remains off-limits for Western LNG trade, the greater the disadvantage for U.S.-Asia commodity routes.

LNG trade has adapted to and mitigated challenges so far, with stable shipping rates despite the need for longer routes. Freight rates have been kept in check because of the rapid expansion of the LNG fleet, which is set to add approximately 72 new tankers this year and grow by 50 percent over the next four years. These additions, combined with only a modest supply increase, have brought spot charter rates below $50,000 per day-quite a contrast to the $131,500 per day average spot rate seen in 2022 after Russia invaded Ukraine.

The longer the Suez Canal and the Red Sea remain a no-go zone, the less competitive U.S.-Asia commodity routes become-especially as the Panama Canal is challenged by drought and bottlenecks-due to increased costs, heightened emissions, and lack of optimization. Between February and August 2024, 91 percent of U.S. LNG bound for Asia took the Cape of Good Hope route, adding approximately 20 days of transit time compared to the Panama Canal, and 10 days compared to the Suez Canal, according to SynMax Leviaton. Currently, 73 percent of U.S. LNG cargoes to Japan take the Cape of Good Hope route, which is a significant change from last year, when Japan could rely more on the Panama Canal for 71 percent of its LNG imports. As a result, Japanese buyers are restating their support for Pacific export terminals from North America and are showing renewed interest in Middle Eastern supply, mostly from Oman.

For LNG cargoes, longer routes mean more boil-off, and while most modern tankers capture and reuse this boil-off as propulsion fuel, combustion of the LNG to power the vessel still leads to varying degrees of methane emissions. Tankers navigating the Cape of Good Hope often face rough seas and strong currents, resulting in higher fuel consumption and increased carbon dioxide and methane emissions.

Efforts by the United States and its allies to restore freedom of navigation in the Red Sea will be key to restoring a sense of security for the industry and LNG importers globally. Importers in northeast Asia are watching closely, as they worry a future war footing in the South and East China Sea and Taiwan Strait regions could disrupt one of their main commodity routes. While there are strong geopolitical reasons to dislodge the Houthis and restore freedom of navigation, the trade arguments should not be overlooked either. With the conflict in the Middle East approaching a tipping point, the United States could seize this opportunity to act against the Iranian proxy and restore freedom of navigation in this highly strategic maritime corridor.