Oil prices surge amid Middle East tensions. What’s next?

Oil prices have stabilized after experiencing their biggest one-day surge in nearly a year, driven by fears that Israel may launch strikes on Iranian oil facilities in retaliation for a missile attack earlier this week.

Brent crude neared $78 per barrel following a 5% rise on Thursday, as President Joe Biden indicated that the U.S. is considering whether to back potential Israeli strikes on Iran’s energy infrastructure. A U.S. official later clarified that discussions are ongoing with Israel, and no final decision has been made. Meanwhile, West Texas Intermediate crude hovered around $74.

Oil prices have climbed roughly 8% this week, marking the largest increase since early last year. This surge is attributed to escalating hostilities, raising concerns over potential disruptions to Middle Eastern oil supplies.

The ongoing tensions between Israel and Iran, along with Iran-backed groups in Lebanon, Gaza, and Yemen, have fueled fears of a broader conflict that could draw in other nations.

Earlier this week, Iran fired a barrage of missiles at Israel in response to intensified Israeli offensives against Hezbollah, a Tehran-backed group, including the deployment of Israeli forces to southern Lebanon. In response, the G7 called on regional powers to "act responsibly and exercise restraint."

Middle East oil supply

The Middle East accounts for approximately one-third of the world’s crude oil supply. Recently, Iran has been producing around 3.3 million barrels of crude per day, making it OPEC's third-largest producer.

Citigroup has estimated that a significant Israeli strike on Iran’s oil export infrastructure could remove 1.5 million barrels of daily supply from the global market. In the case of minor infrastructure damage, the loss might range from 300,000 to 450,000 barrels.

There are also concerns that Tehran could retaliate by targeting the energy infrastructure of neighboring countries or key supply routes, including the crucial Strait of Hormuz. Clearview Energy Partners warned that disruptions in this narrow passage at the mouth of the Arabian Gulf could drive oil prices up by $13 to $28 per barrel.

If sustained, this spike in oil prices could rekindle inflation, just as central banks—including the Federal Reserve—have begun to ease interest rates following a slowdown in price increases.

Bullish sentiment

Warning signals are flashing in the options markets as investors place bets on further oil price hikes. Brent crude call options, which profit from rising prices, have reached their highest level compared to opposing put options in over a year. Implied volatility has also surged dramatically.

Despite the crisis, the OPEC+ alliance reaffirmed its plan to gradually return some barrels to the market by December.

Meanwhile, Libya has resumed oil production following a de-escalation of the country’s political crisis. However, the broader economic outlook remains fragile, and it is uncertain whether China’s massive stimulus package will significantly impact demand in the world’s largest oil-importing nation.