The Fuse

Saudi Arabia-Iran Conflict, Rising Middle East Tensions Add to Oil Market Uncertainty

by Matt Piotrowski | January 05, 2016

The oil market’s initial reaction to the sharp rise in tensions between Saudi Arabia and Iran has been muted, but the events are still troublesome because they heighten tensions in an already volatile region.

The oil market’s initial reaction to the sharp rise in tensions between Saudi Arabia and Iran has been muted, but the events are still troublesome because they heighten tensions in an already volatile region and bring about the unlikelihood that any reconciliation will occur between the two OPEC rivals. The deteriorating relations between the two major oil producers amid the Saudi execution of several Shia prisoners, including a prominent cleric who was among 47 people put to death this past weekend, add a key uncertainty to oil markets in the upcoming year, and for the longer-term stability of the Middle East, home to some 57 percent of the world’s proven oil reserves. But so far prices haven’t shot up on the latest news, since the global market remains glutted and there has not been an actual physical supply disruption.

“Even though this is the strongest direct tension between Iran and Saudi Arabia since the 1980s, the possibility of a military clash or any action that could interrupt the oil production and supply flow of the two countries is very less likely,” Sara Vakhshouri, president of Washington-based consultancy SVB Energy International, told The Fuse. “Both countries are heavily dependent on their oil revenue, particularly at the current time of low oil prices.”

Bearish development for the short term

The conflict may actually drive down prices in the short run, given no unexpected supply disruption occurs, as Iran and Saudi Arabia will be more determined to fight for market share to boost sales. Iran is set to increase its exports by .5 mbd this year and Saudi Arabia is pumping well above 10 mbd. “Ironically, the events could actually contribute to the market’s expectation of oversupply in the near future as it loses hope in cooperation between the two countries to control output,” said Vakhshouri.

The conflict may actually drive down prices in the short run, as Iran and Saudi Arabia will be more determined to fight for market share to boost sales.

There was little likelihood that the two OPEC producers would have taken coordinated action to lift prices in 2016, but any possibility has now gone by the wayside. Tehran hasn’t been pleased with Saudi Arabia’s strategy embarked in November 2014 to pump all out, but now it is likely even more hostile toward the Kingdom’s oil market plans.

Relations between Saudi Arabia and Iran have been strained for some time. But crucially, the brutal executions, which have been followed by Saudi Arabia severing ties with Tehran after a mob stormed the Saudi Embassy there, deepen the schism between Sunni and Shia in the Middle East. This backdrop guarantees it will be more difficult for the international community to implement solutions for other conflicts in the region, such as those in Syria, Iraq and Yemen, where Sunni-Shia tensions are on the broil.

“The question is, does the dispute spill over into military conflict? There is potential movement in that direction,” David Weinberg, Senior Fellow at the Foundation for Defense of Democracies, told The Fuse.

Weinberg said the most likely violent scenarios would be proxies in Bahrain, Iraq or the Eastern Province of Saudi Arabia instigating violence to retaliate against Sunnis. As of Monday, two Sunni mosques were bombed in Iraq in reaction to the executions over the weekend, a possible sign of what is to come.

U.S. foreign policy becomes even more difficult

The escalating crisis between the two heavyweight producers reflect how instability tied to oil threatens consumers and U.S. foreign policy, and could spur higher prices and more volatility once fundamentals eventually tighten.

The escalating crisis between the two heavyweight producers reflect how instability tied to oil threatens consumers and U.S. foreign policy, and could spur higher prices and more volatility once fundamentals eventually tighten. The U.S. has always been lenient in its criticisms of Saudi Arabia, in large part because it produces 11 percent of global crude oil supply. The Obama administration has uttered only mild rebukes of Saudi Arabia’s actions this weekend, even though Riyadh’s provocation further complicates the U.S.’ goals in the region, which include fighting the terrorist group the Islamic State, brokering peace negotiations in Syria, and implementing the nuclear deal with Tehran—which Riyadh had vehemently opposed.

Saudis have ‘higher risk tolerance for hawkish acts’

“The Saudis see the Islamic State as a genuine threat, but they evidently don’t see it as the top threat, particularly outside the Kingdom’s borders.”

The execution of Sheikh Nimr al-Nimr was a clear signal from the Saudi leadership. It knew exactly what type of response the country’s actions would provoke. The executions come against the backdrop of continued Saudi airstrikes on Shia Houthis in Yemen, which have angered Iranians. “The new leadership in Saudi Arabia has shown a higher risk tolerance for hawkish acts,” said Weinberg. “It believes that the mass executions were rational and a fair part of Saudi justice. The Saudis may double down escalation in hopes of eliciting tougher measures against Iran.”

Despite the difficulties posed for the U.S. by the Saudis’ actions, the Kingdom has not been a close ally to begin with in the fight against the extremist group the Islamic State. “The Saudis see the Islamic State as a genuine threat, but they evidently don’t see it as the top threat, particularly outside the Kingdom’s borders,” said Weinberg.

Shale boom mitigates risks in the Middle East

The market has been able to brush off unrest occurring in oil producing countries, thanks to the sharp rise in U.S. oil output throughout the first part of this decade.

With oil prices kept in check, the geopolitical crisis between the Saudis and the Iranians will not likely impact consumers in the current environment. Just like it has done with risks over the past year and a half, the market has been able to brush off unrest occurring in oil producing countries, thanks to the sharp rise in U.S. oil output throughout the first part of this decade. When the market tightens again, however, geopolitical turmoil will matter once more and ultimately lift the price of oil, undermining U.S. consumers and economic growth.