What the Saudi-Iranian Spat Means for Oil Prices

Saudi Arabia has announced that it’s cutting all diplomatic ties with Iran. The decision comes as yet another blow to regional stability. We won’t spend time looking at the social and political implications of this, large as they are. Instead, we’ll focus on the incident in the context of oil, and what it means for prices in the short term.

Of course, dissecting this development is easier said than done. There are many layers to consider, making motives harder to pin down. Yet concentrating on what started this conflict might give us some clues. Before we touch on that, here’s the ABC reporting on the announcement:

Saudi Arabia is cutting ties with Iran after its embassy in Tehran was set on fire by protesters angry at the kingdom’s execution of a prominent Shiite cleric.

The move to sever ties comes amid a worsening diplomatic crisis between the regional rivals following the kingdom’s execution of prominent Shiite cleric Sheikh Nimr al-Nimr.

Speaking at a press conference in the capital Riyad, Saudi Foreign Minister Adel al-Jubeir said Iran’s diplomatic mission and related entities in Saudi Arabia had been given 48 hours to leave the country.

There are concerns the execution of the prominent Shiite cleric will further inflame sectarian conflicts between Iran and Saudi Arabia and Sunni and Shia communities around the world.

US Democratic presidential candidate Hillary Clinton said the death of Sheikh Nimr would inflame tensions in the Middle East and the execution was “not a smart decision to make.

Trying to blame on any one party probably misses the point of the dispute. Here’s what we know.

We know that Iranian protestors set fire to the Saudi embassy in Tehran. We also know they did so as a response to the execution of a key Shia (or Shiite) cleric by the Saudis. Shias are a majority in Iran, making up 35% of the population. Anything that attacks Shia Muslims is an attack on Iran as well, in the view of the Iranians.

In Saudi Arabia, however, there’s an entirely different dynamic at play. Shia Muslims are a minority, accounting for just 10% of the population. The Sunni’s, by comparison, make up roughly 85% of the population. The ruling House of Saud considers itself Wahhabi, or Salafist. That’s important to note because Wahhabism is an ultraconservative branch of Sunni Islam. Punishment for certain misbehaviours can, and often does, lead to execution.

The Saudi’s executed Nimr al-Nimr knowing fully well that Iran would react as it did. They must have known the outrage his execution would spark across the Shia Muslim world. Rarely in the world of politics do things happen by chance. What seem like accidents are often calculated moves.

Despite the reaction they should have known it would provoke, the Saudis went ahead with it anyway. Why?

The Saudis and Iranians don’t get along at the best of times. These are both regional powers who vie for the domination of the Middle East. Alongside Turkey, they each see the region as their playground for exerting influence.

Seen from this perspective, it’s entirely possible the Saudis just didn’t care about blowback. In Iran they see a nation with which they share loose ties. Perhaps they thought there was little to lose. In fact, the only real link binding these two is their membership in OPEC.

As you might be aware, OPEC is a cartel that sets oil prices through supply manipulation. And it controls some 80% of the global oil supply. The persistent low oil prices you’re seeing today is all OPEC’s doing. It could send prices shooting up overnight, if it really wanted. It’d just have to relax its supply driven market share strategy. There’s no bigger influence on global oil prices than OPEC. Which makes any bickering between key member nations a cause for concern.

It’s not unheard of for OPEC members to wage war against each other either. Iran and Iraq did just that between 1980 and 1988. But it’s rare enough to raise eyelids when it happens anyway.

There’s no logic to what should happen when OPEC is at odds with itself. Particularly so when it involves such key members as Saudi Arabia and Iran. Nonetheless, there is a repeating pattern when it does happen. We’ve seen in the past that prices tend to spike whenever conflict of any kind touches the Middle East. This particular incident is proving no exception to the rule. Since resuming trade on Monday, Brent crude oil is up 6.5% to US$38.47.

Oil prices are likely to remain low for the rest of 2016

The spike in oil prices was driven almost entirely by the incident over the weekend. According to CMC Markets Ric Spooner, traders are now building risk premium into prices. That’s leading to a spate of short covering on oil markets. He notes:

While there is no immediate threat to production implied by this situation, political unrest that directly impacts major OPEC producers is unsettling.

Oil markets will be concerned that this could be an incremental step in a deteriorating political situation that might ultimately threaten world oil supply.’

As Spooner says, oil supplies are likely to remain unchanged. In fact, oil supply is only likely to increase this year. With the easing of sanctions, Iranian oil will be back on the market big time at some point this year. That’s set to load up to 500,000 extra barrels onto the market.

That doesn’t suggest prices will trend anywhere but down in 2016. Only war, and the closure of the Strait of Hormuz, could threaten oil prices at this rate.

In any case, we shouldn’t be quick to assume that this political spat will turn into something bigger. There’s no suggestion that a physical confrontation is on the cards. Neither the Saudis, nor the Iranians, have any desire to enter into military conflict.

Right now, the Middle East is undergoing a dramatic shift. There’s a lot of potential for power grabs by the region’s major players. The chaos in Iraq and Syria is leaving a vacuum that Turkey, Iran and the Saudis are hoping to fill.

If conflict between one another, even by proxy, can be avoided, even better. In saying that, the breakdown of political ties between regional powers doesn’t help matters. And they have a habit of making markets very edgy too.

In all likelihood then, the oil price spike will lose steam. Probably even as early as this week. Saudi Arabia and Iran have poor relations at the best of times. Unless they enter into a war over this, nothing much has changed. War is no stranger to the Middle East of course. But we’re a long way from conflict erupting on the Persian Gulf just yet.

Once markets realise the effects of the spat are limited, prices are likely to fall back again. For oil, we can expect 2016 to be much like 2015. That’ll remain the case as long as market share dominates OPEC’s strategy.

Mat Spasic,

Junior Analyst, Markets and Money

Markets and Money offers an independent and critical perspective on the Australian and global investment markets. Slightly offbeat and far from institutional, Markets and Money delivers you straight-forward, humorous, and useful investment insights from a world wide network of analysts, contrarians, and successful investors.

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