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Oil prices jumped as much as 4% on June 13th following attacks on two Japanese tankers near the Strait of Hormuz in the Persian Gulf. The attacks occurred shortly after Shinzo Abe, the Japanese Prime Minister, had met with Iranian officials. While the source of the attack was not known, the timing and objects of the attacks seems to point toward Iran or Iranian rebels in Yemen as the likely source. The incident is one in a long history of sabotage activity in the area and threats to shut down the shipping channel. Previous incidents eventually faded into memory with oil prices returning to pre-existing levels. This time may be different.

The location of the attacks was key. This time the attacks were near the Strait of Hormuz, the world’s busiest sea lane for oil shipment. Almost 30% of the world’s traded oil is shipped through the Strait, mainly to destinations in Asia such as Japan, India and China. The Strait is 60 miles across, but shipping channels are only two miles across making tankers very vulnerable to attacks from torpedoes or mines.

Further escalation would cause oil prices to rise even more. It is very possible that the United States will respond to the attacks by increasing its presence in the Strait. Such a move could escalate tension in the area, as well as the likelihood of further attacks. Should the United States respond with an aerial attack on Iran, oil prices will undoubtedly rise. A senior Iranian military official warned on June 2^nd that any rocket attack would hike up the price of oil above $100 per barrel.

The United States may be backing Iran into a corner. Iran’s budget calls for one-third of the government’s income to come from oil and gas exports. In November 2018, as part of a decision to exit the Iran nuclear agreement, the Trump administration announced major sanctions against Iran preventing Iran from selling oil to other countries. However, it granted waivers to eight countries, five of which (India, China, Japan, South Korea and Turkey) exercised their waivers. These waivers were eliminated in May. By virtually eliminating Iran oil sales, the United States may be pushing Iran into a position in which it feels it has no option but to attack.

This has happened before and then died down. The attacks bore similarities to sabotage activity on May 12^th, which was followed by claims from Iranian officials that the Strait of Hormuz would be shut down. In fact, Iranian officials have threatened to close the Strait of Hormuz five times in the last eight years. Each time, the United States reacted by increasing its presence in the area and the attacks ceased. One would have to go back to 1998 to find a significant response by the United States. After a U.S. frigate was damaged by an Iranian mine, the United States responded by sinking or severely damaging half of Iran’s operational fleet.

Iran may be standing alone. The United States has indicated that any attempts to close the Strait of Hormuz would be viewed as an act of war. With the majority of oil in the Persian Gulf being shipped to India, Japan and China; the United States would have powerful allies in any conflict with Iran. When Iran threatened to close the Strait of Hormuz in 2012, it backed off its threats after a stern warning from China’s then-premier, Wen Jiabao.

The United States can increase oil production, if oil prices remain high. Independent producers in the United States have identified tens of thousands of prospective drilling locations. Some of these are economical only at higher oil prices. Should oil prices remain at high levels, we would expect companies to increase their drilling efforts to offset any drop in supply. This would dampen the rise in oil prices, at least domestically.

The oil price impact of the attacks will be offset by other factors. The demand for oil has been decreasing in recent quarters in response to expectations of a global economic slowdown. In fact, on the day of the attacks, OPEC announced that it was cutting its forecast for oil demand growth in 2019. Further economic weakness would reduce the global demand for oil, partially offsetting any reduction in supply.

Tensions with Iran are accelerating. And, although there is a history of tension followed by détente, this time appears to be different. Sanctions against Iran have left the country with few options but to fight. It seems unlikely that Iran is going to back down and agree to another nuclear accord. At best, it may pull back from aggressive activity and hope the conflict blows over. Under such a scenario, oil prices could remain at elevated levels for some time period with periodic spikes should the conflict escalate.

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Long Story Short - An escalation of tension with Iran could cause oil prices to soar
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