Oil price surge on US/Iran

Geopolitical risks are rising this morning, after attacks on commercial vessels in the Strait of Hormuz on Tuesday led to retaliatory strikes by the US overnight. Iran has resumed attacks on its Gulf neighbours, including reports of strikes against Bahrain and Kuwait, and President Trump has just said that the ceasefire is over.

It is worth noting, that the President did not explicitly state that the war is back on, and he backtracked slightly by saying that he will let his negotiators deal with it. However, today’s events suggest that the diplomatic path to ending this war is not easy.  

Financial markets have immediately repriced the rising geopolitical risks. Indices across Europe are falling broadly, and the FTSE 100, the Dax and the Cac 40 are all down more than 1.5%. The oil price is surging and is higher by more than 6% this morning and Brent crude is trading back above $78 per barrel.

Diplomatic efforts to end the war hit a stumbling block

While we have seen escalations in tensions between Iran and the US in recent months, this week’s event are a sign that diplomatic efforts to end the war have ground to a halt. Trump did not explicitly say that he would re-start the war against Iran, but he showed his frustration with the Iranian regime while at a Nato summit in Turkey.

Oil majors surge

This news has had a cascading effect on markets. Unsurprisingly, the oil majors are surging on Wednesday, and BP and Shell are leading the FTSE 100. BP is higher by more than 3% this morning and is even outperforming defense names. A rising oil price is raising fears about inflation, and global bond yields are soaring, especially in Europe. The 2-year UK yield is up more than 9bps today and the Italian 2-year yield is higher by nearly 10bps.

The rise in the oil price is leading to a recalibration of rate hike expectations, although there is still only one rate hike priced in for the US this year, and less than 50% chance of a second hike. If the geopolitical situation deteriorates further or if oil prices rise back above $100 per barrel, then we could see two hikes plus get priced in for the US, the UK and for Europe.

Why oil price gains could be capped, for now

Rising yields and a soaring dollar are weighing on the gold price, which is down nearly 2%. This is weighing on mining stocks, and Fresnillo and Antofagasta are some of the weakest performers on the FTSE 100 today.

This is a fluid situation, and we are waiting to hear about how Iran responds to Donald Trump’s comments. The US has already revoked the waiver on Iranian oil sanctions. At this stage it does not mean that Iran can’t sell its oil, if it finds willing buyers, which it is likely to do, it would have to use non-US dollar settlement for payments, but again, this should not be a problem. For now, this is one reason why the oil price has not surged 10% plus today. For the Brent crude oil price to extend gains above $80 per barrel, we would need to see another US naval blockade of the Strait of Hormuz, which would stop Iran from selling its oil and cause a major escalation in tensions.

Hopes still high for a quick solution

For now, this latest flare up seems contained, although risk sentiment has taken a knock and oil prices have had a substantial jump, this is not a rout. The prevailing view is that this is short term issue that will get ironed out, and it will not trigger a broader conflict. The Iranian regime and President Trump are both volatile and can pivot on their positions quickly. Stock market bulls will be hoping that they do that in the next few days.

If there is an explicit declaration of war by both sides in the near term, that is when we could see the price of oil rise back towards $100 per barrel. It would also lead to a long-term repricing of interest rate expectations, and a significant deterioration in risk appetite.