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• Comments on a possible Israeli retaliation against Iranian energy assets give the market the shakes.
• I believe, should it occur, it might lead to an unexpected outcome.
• Oil market fundamentals since 2020 would tend to argue against this being a huge or long-term negative (or positive for oil prices).
• The myth of “Drill Baby, Drill”

Possible Israeli retaliation vs. Iranian energy assets give the market a case of indigestion.

Although the market ended the week on high note, the previous few days of squeamish market action appear to be a direct reaction to the massive Israeli incursion into southern Lebanon against Iranian proxy, Hezbollah, and the follow-up retaliation by Iran via a heavy missile attack on Israel. This is just but one chapter in the on-again, off-again conflict that Israel has faced since its creation as a state in 1948. My post is not a defense of Israel or the Palestinian sides in this conflict. I will leave that for others. What I am focused on here is the potential ramifications of Israel taking out a portion or all of Iran’s energy infrastructure. 

As usual the media has been whipping this story pretty strongly. Bad news sells, and on the surface this would be bad news as it might push oil prices much higher. Here is a summary comment from CNBC on the views of Swedish commodity analyst, Bjarne Schieldrop: “Oil markets are being too complacent given the risk of major supply disruptions in the Middle East, analysts told CNBC on Thursday, with one warning that crude futures could rally to more than $200 a barrel.” President Biden also commented earlier today on this prospect and added fuel to a big bump in oil prices, WTI up $3.61 (5.15%) last Thursday.

Possibly This Might Lead to Unexpected Outcomes

Why? The Islamic Republic of Iran probably does not have many friends in the region or around the world. As a fanatical theocracy, with burgeoning nuclear capabilities, the Iranians scare a lot of people. Anything that can be done to slow them down in funding terrorism, Hezbollah in Lebanon and their nuclear ambitions would be welcomed. This probably would be especially true for their neighbor/enemy across the Strait of Hormuz, Saudi Arabia.

A second potential benefit of reducing or eliminating a large part of Iran’s energy income might be the destabilizing effect it would have on the Iranian economy and the country itself. The current regime is very unpopular. Domestic concerns might keep them off their game of making the world miserable in pursuit of  their goal, a world bathed in the light of radical Islam. 

On the Upside: recent oil market fundamentals would argue against a huge, long-term jump in prices

Lest we forget, and it seems like investors and the market have an extraordinarily short memory span, a mildly negative US economic statistic or weakness in China can tank the price of oil $2 or $3 a barrel — spiking worry about a potential recession. This obviously is a market in an oversupply condition.

Another important point comes from the fact that Iran is currently supplying 3.2 million barrels a day to the market while Saudi Arabia is producing about 9 million barrels a day (production that has been reined to support current prices). What people forget is that in April of 2020 (you know, when the price of WTI dropped to negative $40 per barrel) Saudi Arabian production averaged approximately 12 million barrels per day. They may not have the capability to produce that much today but even if the number approximated 11 million per day it would cover the loss of 2 million Iranian barrels per day. In other words Saudi production plus that of other producers that has been reined in to support current crude prices could easily recover the loss of every barrel of Iranian crude.

The myth of “Drill Baby Drill”

The United States is the leading oil producer in the world with current daily production standing at about 13 million barrels per day. If massive amounts of federal on-shore and off-shore tracts were open for drilling it would not likely stimulate additional production any time soon. Why? The various producers realize that any abrupt increase in supply would likely put extreme pressure on prices. This is exactly what happened in 2020 when the US increased production dramatically during the shale oil revolution. It was costing Saudi Arabia market share, so the Saudis ramped up production dramatically, thus destroying the crude market. There was so much crude floating around and storage was so full that at one point contract holders who could not take delivery were in a position that they would have to pay people to take it off their hands (ergo the minus $40 a barrel price). 

Another factor at work in 2020 was the growing concern that renewables would be displacing hydrocarbon fuels at sometime down the road. 

This was an extraordinarily traumatic time for the fossil fuel industry. It caused a massive shift in behavior. The “Drill Baby, Drill” philosophy that made it a priority to grow reserves at a faster pace than growing production morphed into to slowing exploration and development drilling and returning those savings to shareholders via increased dividends, stock buybacks and debt reduction. We made this case in detail in a post published July 11, 2022, “Has Warren Buffett Gone Mad?”.

Bottom Lines: We should be able to withstand an Israeli attack on Iranian energy assets. Oil companies are acting in their own economic self interest. The concept of “Drill Baby Drill” goes against that self interest. 

What ‘s your take?

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