Middle East Geopolitical Tensions Ignite the Oil Market: What’s Next?

A sudden outbreak of geopolitical tensions in the Middle East triggered a surge in the crude oil market, leading to a sharp rise in oil prices. Now, two key questions arise:

1. Was there any indication or warning before Iran's missile attack on Israel?

2. How should we assess oil prices after Iran's missile attack on Israel?

Let’s address the first question:

Before Iran's missile attack on Israel, Brent crude oil prices had remained relatively weak throughout the third quarter. Fundamentally, we saw that OPEC+ was preparing to increase production in December, gasoline demand was declining after the summer consumption peak, and earlier U.S. and European economic data consistently underperformed expectations. CFTC speculative net long positions on crude oil also dropped to historical lows. On October 1, Brent crude briefly fell to around $70 per barrel. Everything seemed to be progressing in favor of the bears.

However, the sudden escalation of geopolitical tensions in the Middle East changed all previous expectations. The sudden threat of war triggered a market reaction, as the market quickly shifted from the previous belief that Iran was showing restraint and that Middle Eastern oil supplies would remain unaffected. Brent crude broke through the key resistance level of $75 per barrel and subsequently surged, with geopolitical risk premiums reaching their highest levels in a year.

In fact, if we look at a series of recent events (such as large-scale domestic stimulus, the sharp drop in bond markets, the Russia-Ukraine war, and the escalating conflict between Iran and Israel), we can identify certain similarities. These events tend to catch people off guard, causing significant market volatility when they occur. Initially, there is a period of calm after these events, leading many to believe that risks are manageable and that the market will continue along its previous trajectory, thereby underestimating or overlooking potential risks.

Reflecting on these events, one perspective can help provide clarity and offer a forward-looking approach when similar events occur in the future. I refer to this perspective as "bottom-line thinking in strategic games." This concept involves not only games between nations but also the dynamics between governments and markets.

When an event begins to unfold and gradually draws market attention, various stakeholders engage in a strategic game. As time progresses, unresolved conflicts intensify, attracting even more market focus. The tension reaches a tipping point when conflicts become irreconcilable, which marks the accumulation of risk. This is when the game enters a more intense phase, where quantitative changes lead to qualitative shifts. It’s challenging to pinpoint the exact moment when this qualitative change occurs, so it's crucial to observe the mindset and bottom lines of the involved parties. The market will test these limits. Any action or event that crosses these lines could act as a trigger, causing drastic changes.

Looking at the recent missile attack by Iran, Israel’s actions targeting Hezbollah’s communication infrastructure in Lebanon and a series of assassinations of key leaders crossed Iran’s bottom line. Iran explicitly voiced this concern on September 20, something it hadn’t done over the past year. Given this, Iran's subsequent strong retaliation and declaration of "no longer holding back" becomes more understandable.

The Russia-Ukraine war of 2022 is another illustrative case. NATO’s continued eastward expansion and Ukraine’s transformation into an anti-Russian state, with NATO military facilities rapidly advancing toward Russia’s borders, posed a significant threat to Russia's national security. This seems to have been Russia’s bottom line. Russia's subsequent "special military operation" in Ukraine has persisted ever since. The sudden outbreak of the war far exceeded market expectations at the time, causing Brent crude oil prices to surge to around $140 per barrel.

Another case involves OPEC+’s production cuts to support oil prices over the past few years. Saudi Arabia's bottom line was tied to its fiscal breakeven point, around $85 per barrel. When Brent fell below $80, the market strongly anticipated further production cuts from Saudi Arabia to support prices. The expectation of a price floor was strong. However, after Saudi crude production dropped to a low of 9 million barrels per day, the support from production cuts started to wane.

How should we view the oil market after the price surge?

Israel's retaliatory actions are critical, and there are two possibilities:

1. Targeting Iranian military and nuclear sites: Many of Iran's nuclear facilities are buried deep underground, making them difficult to destroy effectively. This could allow Iran to claim the attacks failed while avoiding further escalation. Such strikes would be largely symbolic, and oil prices may retreat as a result.

2. Targeting Iran’s oil and gas infrastructure: Attacks on refineries, rather than upstream facilities, could negatively impact the crude oil market as this would release more crude oil for export. However, if upstream facilities are targeted, it may further boost oil prices and even trigger a global oil crisis. The key will be assessing the damage to Iran’s crude oil exports, which amount to around 1.9 million barrels per day. Kharg Island is crucial here, as 90% of Iran’s oil exports flow through this hub.

Overall, the short-term balance of supply and demand in the oil market—and the direction of prices—will depend on the scale of Israel's retaliation and whether Iran's upstream energy infrastructure suffers significant damage. As the market waits for Israel’s response, this heightened tension could provide short-term support for oil prices. Volatility in the oil market may further increase following Israeli action, so it is essential to manage risk carefully.