Rising tensions in the Middle East typically trigger a knee-jerk increase in the price of oil. But these are not typical times for the oil market. With several factors already weighing on the price of oil, increasing frictions in this historically tumultuous region are poised to counter-intuitively exacerbate the negative outlook for oil.
Analysts have a plethora of reasons to support the consensus view that oil will remain low for the foreseeable future - the slowing Chinese and stagnant European economies, Saudi Arabia's reduced public subsidies, the impending resumption of Iranian exports, and the recent repeal of the US export ban, just to name a few. The one given caveat to any bearish oil futures call has traditionally been the prospect for an uptick in instability in the Middle East, particularly the Persian Gulf. In fact, the price of oil has always carried an inherent geopolitical risk premium for this very reason.
But to quote Bob Dylan, "The times, they are a-changin'." Over the past year, as the Obama administration led an international effort to strike a nuclear accord with Shiite-dominant Iran, Saudi Arabia and other Sunni-led regimes have adopted a more aggressive posture to confront what they view as Iran's "rising arc of Shiism." The result: an expanding proxy war between the two sides that has swept through Iraq, Syria, and Yemen. And it is set to sweep through the oil market as well.
When the supply glut triggered a precipitous drop in the price of oil last year, the Saudis followed the advice of Obama's acerbic former chief of staff, Rahm Emmanuel, by "never letting a serious crisis go to waste." Saudi Arabia - with the largest and cheapest reserves in the world - surprised the world by refusing to slow its pumping, making much of America's unconventional production simply no longer cost-effective in comparison. The targeted nature of this move was underscored when the Saudis offered discounted prices to its Asian and European customers.
Meanwhile, Iran has reportedly moved faster than many experts expected to meet the initial conditions of the nuclear agreement - and consequently to ramp up the exports of its own oil soon. In accordance with former House Speaker Tip O'Neill's adage that "all politics are local," President Hassan Rouhani is looking to have the deal implemented before his country's parliamentary elections next month. As the reasoning goes, getting the US and other members of the P5+1 nations that negotiated the accord to certify its implementation would provide sanctions relief - including the unfettered resumption of Iran's oil exports - which Rouhani would like to provide as an arrow in his political allies' quiver during the election campaign.
The Obama administration also wants Rouhani and other so-called Iranian moderates to have this tool, particularly since the Feb. 26 polling will include the appointment of a new Council of Experts that carries an eight-year term and will almost assuredly choose Iran's next supreme leader. This is why the Obama administration apparently has chosen not to respond in a timely manner to Iran's recent military provocations - including, a ballistic missile test and a live-fire exercise near a US Navy aircraft carrier in the Strait of Hormuz - ascribing such moves as attempts by Iranian hardliners to scuttle - or at least delay until after the elections - the nuclear agreement's implementation and connected sanctions relief.
With all sides pushing to get Iranian oil exports back online, one million barrels per day of Iranian crude exports are expected to be added to global supply in the coming months, and Saudi Arabia has only greater incentive to drive oil prices lower. Beyond the commercial aim of protecting its market share from US shale players, it now has the overriding political goal of depriving Iran, which the Saudis view as an existential threat, of much-needed revenues.
The latest escalation between these two Gulf regional powers must be considered within this broader context. Saudi Arabia executed a prominent Shiite cleric over the weekend, Iranians stormed the Saudi embassy in Tehran, and the Saudis countered by severing diplomatic ties and flights between the two countries, along with some of their Sunni neighbours. These actions are just another way of fighting for control in a region where black gold rather than cash is the true king and the Saudis hold most of the cards. In essence, the Saudis are replacing the geopolitical risk premium with a previously unimaginable geopolitical risk discount. It's the Middle East's own version of a Cold War, and as Carl von Clausewitz so aptly put it, "War is a continuation of politics by other means."