Oil Markets on Edge: Brent Crude at a Crossroads Amid Iran-Israel Conflict

A break above $78.50 in Brent crude and certainly above $80 would therefore require evidence that crude exports will be impacted and/or a third party enters the conflict. That party, at this point, is seen as the US, but what that involvement looks like – either diplomatically or militarily - is the subject of much debate, with both scenarios offering an opposing impact on the crude price.

Anticipating Trump’s next move

Many have questioned Trump’s motives for leaving the G7 Summit early today and calling the National Security Council to convene in the Situation Room upon his return to D.C. The US, Russia and Chinese governments have all instructed nationals to leave Tehran and Israel, and the USS Nimitz aircraft carrier has left port earlier than expected and is now headed to the Middle East.

As was reported yesterday by the WSJ, Iran has expressed a willingness to come to the table for talks, but that is fully conditional on the US not becoming involved militarily. So it’s clear that Trump’s next move is critically important if we are to see a ceasefire and a deal involving Iran’s nuclear capabilities.

Whether that next move from the US is to send in military personnel into the region to protect US interests and to accelerate the potential peace talks – with Trump even potentially heading to the region himself. Or, conversely, and seemingly less likely, offering military capabilities to Israel – possible in the form of bunker busters – sits at the centre of the debate.

Media reports have detailed that the US will NOT provide military assistance to Israel, but the market is keeping an open mind on what plays out over the next 24 hours.

Talks could push crude towards $65

Should the market feel a higher probability that talks are probable and could result in Iran agreeing to give up its nuclear capabilities, then much of the geopolitical risk premium priced into crude since last Wednesday could be unwound, resulting in our cash crude price trading to $65 or lower.

Things rarely run that smoothly though and with many on edge for a sharp escalation in the conflict, one needs to be open-minded to increased near-term volatility driven by the impending headline risk.

As suggested above, another consideration for oil traders is the possibility that Iranian oil and gas export infrastructure sites are impacted – while we can’t rule this outcome out, this scenario does seem a lower risk, as it would be seen as a significant escalation that would pull Iran further from the negotiating table and ultimately see Brent crude trade above $80. It would also receive strong condemnation from China (the big buyers of Iranian crude) and other Middle Eastern countries, many of whom would be concerned about the prospect that their own facilities could come into play.

A disruption to the Strait of Hormuz: The major tail risk

The obvious tail risk for crude (and global markets) would be a disruption in the Strait of Hormuz – for now, the market feels this extreme outcome is perhaps a 5% probability at most, and would only become a reality if Iran was willing to risk it all – Of course, if the market did increase the probability that this key logistical channel was even remotely in play then crude could be trading well north of $90 – but one also suspects any disruption wouldn’t last long.

What is the trade?

That is clearly a tough question to answer – while the base case is that a deal will be struck at some stage, and/or that the conflict should be contained with supply unlikely to be impacted to any great degree, initiating a short position in crude for that eventual base-case outcome comes with a high degree of risk, with headlines raising anxiety levels and pushing crude towards $80 – the Oil VIX at 60% portrays that well. We can also see that the crude futures curve has pulled into strong backwardation, detailing that front-month futures contracts may have already discounted a tight near-term oil market.

A futures curve in backwardation typically incentivises commodity traders to hold long positions (for carry) – however in the case of geopolitical conflict, the opposite seems true, and the market may have discounted a loss of supply that may well not eventuate.

Good luck to all.