Brent fell below $100 per barrel on Wednesday after US President Donald Trump pushed a 15-point plan to cease hostilities with Iran. Markets reacted to optimism over ending the conflict, sending oil lower, gold higher, and unravelling some of the safe-haven flows seen at the start of the week. The episode raises concerns about a potential oil crash if hostilities cease. The current market situation is driven more by speculation than underlying fundamentals.
The reality is that the closure of the Strait of Hormuz does provide a major supply shock to the market. It is, after all, the largest oil market disruption ever. On the other hand, the resumption of shipments from the Gulf will have an equal and opposite major impact on the world. Analysts talking about $150 or even $200 oil are looking at the worst case scenario, where oil infrastructure is destroyed and takes years to recover. While that is still a possibility, we are still well within the range where an announcement of a peace deal, or even just a reopening of the Strait of Hormuz, could plunge crude prices much lower. The war has been going on for less than a month at this point, and there is some inventory buffer in the system.
Transit Is Cut, Not Supply
The issue is that many entities in the oil-producing system have become acutely aware of the vulnerability of sending so much crude through such a narrow gap. Just like with the restrictions put on Russia following its invasion of Ukraine, the oil market has been rebalancing. But, unlike the 2022 episode, the market is much more prepared, and suppliers have been quicker to react.
The region most affected by the crisis is, of course, Asia, the destination of over 90% of the crude oil produced in the Persian Gulf. Almost immediately, major importers like China sought alternative sources, such as from Africa, in a bid to diversify their energy sources. OPEC countries are ramping up production to meet demand.
The Return of the Supply Glut
India, the second-largest buyer of Middle Eastern crude, is now planning a $20 billion investment to expand its domestic petroleum production. Meanwhile, Gulf nations are filling every available storage capacity to avoid cutting back production during the crisis.
Before the war, analysts were worried about an impending oil supply glut. That concern could come crashing back if transit through Hormuz is quickly restored, as bottled-up crude becomes available amid the release of strategic reserves and production expansion. This can be exacerbated if the Trump administration reaches a deal with Iran similar to Venezuela that would allow even more oil to come on the market.
How Low Can Brent Go?
Depending on the kind of deal that is reached to end hostilities in the Middle East, crude prices could collapse not just back to where they were before the war started. In fact, the threat of a conflict had elevated crude in the latter part of February. Prices could fall significantly below February levels, particularly if central banks raise rates and slow the economy, which would reduce demand for crude.
Markets are currently pricing in the risk of the war lasting for an extended period, rather than the underlying market fundamentals. Asian markets are experiencing a supply crisis because it takes time to redirect energy from the Atlantic Basin, where inventories are still available. Ships that sailed before the war began are still arriving. If the conflict is resolved soon (as in, potentially, Thursday, when there are reports of a possible high-level meeting), crude prices could remain elevated for a bit as the market rebalances. But the subsequent wave of supply could force prices down more than expected, potentially triggering an oil crash.