The ongoing conflict in the Middle East, particularly the escalation between Israel and Iran, is sending shockwaves through the global oil market. Following Iran’s attack on Israel, oil prices surged by 6%, reaching levels unseen since August, though still below the highs witnessed earlier this year. Many are left wondering: why haven’t prices risen more significantly, and what does the future hold?
Why Oil Prices Are Rising—But Not Too Much
To understand the dynamics behind the current price movements, it's important to recognise the sensitivity of oil supply and demand. Both are inelastic, meaning that when disruptions occur, prices tend to spike sharply. We saw this when Russia invaded Ukraine in 2022, leading to concerns about a 3% drop in global oil supply. The result? A 30% surge in oil prices within days, before stabilising over the course of the year.
Now, with Tehran's recent missile strikes and the prospect of further escalation, a potential oil supply shock looms large. Iran accounts for roughly 4% of the world’s oil production and 2% of global oil exports. If Israel responds by targeting Iranian oil infrastructure—such as the Kharg oil terminal, which handles 90% of Iran’s exports—the impact on global oil supplies could be significant, leading to much sharper price increases.
However, oil prices haven’t yet skyrocketed for several reasons. Firstly, China’s reduced demand and OPEC’s ability to fill supply gaps have helped stabilise the market. Secondly, there’s a level of uncertainty: while an escalation is possible, markets tend to price in the likelihood of such events well in advance. The risk of full-scale conflict is present, but it hasn’t fully materialised yet.
How Oil Prices Affect Energy Prices
When oil prices rise, it doesn’t just affect the cost of gasoline or transportation—there’s a much broader impact on energy prices across the board. Oil is a key input in the global energy mix, particularly in countries that rely heavily on oil-fired power generation or transportation fuels. Even in countries where natural gas or renewables dominate electricity generation, oil prices can still influence energy costs.
Electricity Generation: In many parts of the world, oil is still used to generate electricity, especially in regions where alternative energy sources are limited. When oil prices rise, the cost of producing electricity increases, pushing up energy bills for consumers and businesses.
Natural Gas Prices: Oil and natural gas prices are often linked, particularly through long-term contracts where the price of gas is tied to the price of oil. A spike in oil prices can therefore lead to higher natural gas prices, even in countries where gas is a primary energy source. This has been particularly evident in Europe, where gas prices have been influenced by both the conflict in Ukraine and global oil market dynamics.
Transportation and Logistics Costs: Energy costs for transportation—such as shipping, aviation, and road transport—are directly influenced by oil prices. As fuel costs rise, so do the costs of moving goods and services. These increases are often passed on to consumers, leading to higher prices across a range of sectors, from food to manufacturing.
Inflationary Pressures: Rising oil prices contribute to broader inflationary pressures. As energy costs increase, businesses face higher operating expenses, which can lead to higher prices for goods and services. This, in turn, affects everything from household energy bills to the cost of everyday items, further straining consumer finances.
Renewable Energy Impact: In the short term, higher oil prices make renewable energy sources more competitive. However, it also makes fossil fuels more expensive to phase out, as countries may be forced to rely on oil or natural gas to meet immediate energy demands, particularly in the absence of sufficient renewable infrastructure.
Potential Regional Escalation and Risks to Oil Supply
The bigger risk comes from potential disruptions to the Strait of Hormuz, a key artery for global oil shipments. About 20% of the world’s petroleum consumption passes through this chokepoint. In the past, Tehran has demonstrated its willingness to disrupt global oil flows to make a statement, seizing tankers and aiding Houthi rebels in attacks in the Red Sea. A similar incident in 2019, when a drone attack on Saudi oil facilities knocked out 5% of global oil supplies, sent oil prices soaring 20%.
If the conflict intensifies and Iran or its proxies target oil facilities or shipping lanes, the world could face a much more severe supply shock. Energy markets are watching closely, as an attack on key Saudi or UAE oil facilities would undoubtedly send prices surging, exacerbating the global energy crisis.
The Ripple Effect of the Ukraine War
The conflict in Ukraine has already taught us how a regional war can have global energy consequences. Following Russia’s invasion, Europe experienced a crippling energy crisis as gas and oil supplies were disrupted. Russia, one of the largest suppliers of energy to Europe, saw its exports sharply curtailed by sanctions, and energy prices spiked as a result. Though Europe has since diversified its energy sources, the scars of that crisis remain. Gas prices, while below their 2022 peaks, still haven’t returned to pre-war levels, and stocks are being carefully managed ahead of winter.
The possibility of another oil shock—this time driven by Middle Eastern tensions—could deliver a third major blow to Europe in just five years, following the pandemic and the Ukraine crisis. The International Monetary Fund (IMF) has warned that a doubling of oil prices could knock 1-2% off the euro area’s GDP, tipping it into recession.
What the Future Holds
In the long term, energy markets are bracing for more volatility. The war in Ukraine has already underscored the need for energy security and diversification. Both the UK and Europe have made strides towards reducing their reliance on Russian gas, but the Middle East remains a critical supplier of oil. Any further disruptions would force governments to rethink their energy strategies once again.
In the short term, the Middle East conflict will remain the biggest driver of oil price movements. While markets are not fully pricing in a major escalation yet, the situation remains fluid. As the conflict evolves, so too will the energy landscape, and businesses and consumers alike should be prepared for potentially higher prices.
In conclusion, the current rise in oil prices reflects uncertainty rather than panic, but that could change quickly if the conflict spreads or deepens. For now, the market is holding its breath, but any significant disruption to oil supplies could send shockwaves through the global economy and drive energy prices even higher.