Kissler: The Challenge for Oil is Falling Demand, Despite Heightened Middle East Conflicts

Ever since Iranian-backed Houthi rebels began attacking ships in the Red Sea in November, there’s been the risk that oil supplies could be disrupted, if the situation were to escalate—and in many ways, escalate it has. The Yemen-based rebels continue to attack commercial ships, which extended shipping times for companies choosing to instead go around the Horn of Africa, and increased shipping costs. Then, in late January, a drone attack in Jordan killed three U.S. service personnel and injured more than 30. That was the first time U.S. troops were killed by enemy fire in the Middle East since the beginning of the war in Gaza. Yet, contrary to what one might expect, crude prices have actually showed a lackluster performance.

In fact, crude futures have recently traded at mostly a sideways choppy pattern. Yes, there has been a $2/bbl to $4/bbl increase in prices, but that may have had more to do with cold weather-related production issues in the Dakotas than actual fear of oil transportation in the Middle East being disrupted.

Lower demand in China and U.S. dragging down prices

The point being made here is that more traders are beginning to fear a fall in global demand than they are a supply disruption by militants. Indeed, the facts so far support the greater risk of the former. One factor is slower economic growth in Asia, particularly in China. The Hang Seng Chinese Stock Index has shown a 7% to 8% drop, just since Jan. 1. When you take into account that China is globally the largest importer of crude oil, traders’ greater fear of falling demand—as opposed to fallout from the Red Sea attacks—is understandable.

Furthermore, China’s slow economic recovery is not the only potential headwind for oil prices. U.S. gasoline demand also dropped substantially in the last two months. Although a decline tends to occur this time of year, the degree is what’s surprising. Demand for this time of year is well below the five-year average, according to data from the U.S. Energy Information Administration (EIA). This decline might be due to the three-week-long major cold temperatures seen across the U.S., which may have put a damper on automobile travel. However, another more lasting factor may be the fact that it now seems that the Federal Reserve will keep U.S. interest rates higher for longer than many expected. These higher rates have been weighing on the average U.S. consumer’s pocketbook, which includes fuel purchasing.

Middle East conflict still a risk to oil supply

Even though demand is the bigger weight on traders’ minds right now, the Red Sea attacks and, moreover, the U.S.’ “shadow war” with Iran still has the potential to impact the global oil supply, and consequently, prices. Iran currently exports around 1 MMbbl/d. If a major event were to occur—such as the Houthi rebels were to sink an oil tanker, resulting in harder sanctions on Iranian oil—those million barrels a day of Iranian oil would certainly be missed.

That said, the resulting increase in prices would likely be minimal over the long run, as other OPEC nations could quickly fill the void. The last time the U.S. had a major attack on Iran was in 1987, and seemingly prices bolted approximately 3% higher the first few days, only to be right back down the following weeks.

Of course, as with any military engagement, anything can happen, and a major escalation to ground troop involvement by the U.S. and Iran could easily cause a very quick dramatic rise to prices. However, in the near-term, volatility will remain in focus, though all eyes will be on Middle East tensions in addition to global demand.