Manufacturing Energy Crises

How the market loves the Middle East crisis

It was a bad month for oil.

Oil has been struggling to pull in the big bucks recently, with the price dropping below $70 per barrel, the lowest since December 2021. The OPEC group had been cutting production since November 2022 in response to this drop, trying to stimulate the market into spiking the price, which averaged at $99 per barrel that year. Saudi Arabia had even set a price target of $100 per barrel which, according to the IMF, the nation needs to balance its budget. But the group’s actions were undermined by non-OPEC producers steadily supplying the market, particularly the United States. This led to Saudi Arabia announcing a few weeks ago that it would push forward with planned production increase despite the low price, effectively resigning itself to a period of lower oil prices, as the FT reported.

On top of this, September is notoriously bad for the stock market and is the only month to average negative returns. This is known as the “September effect” and has been the case since 1928. Coupled with prices that wouldn’t budge, which saw the U.S crude oil prices post a third monthly loss, energy traders were being bearish. “Oil markets are experiencing a panic attack,” Amarpreet Singh, Barclays energy analyst, told clients in a Friday note, reported CNBC.

And then, on Tuesday October 1, in response to rampant Israeli aggression throughout the region, Iran launched 200 missiles at Israel.

The United States had warned Israel of the attack that morning and energy markets had responded in kind. Before the first missile was launched, oil prices were up a few percentage points. By the end of the day, they were up more than 5%, with Brent trading at $73.35 per barrel.

Why does the market respond positively to an attack? Out of the belief oil may soon become scarcer than previous months, making it a more valuable resource to both have and trade. This same belief was parroted, albeit framed differently, by press and politics. The fallout of the attack, they surmise, is that Israel will target Iran’s oil infrastructure which will boost prices—but increase volatility. Iran, in response, could then target the 13 million barrels per day of crude oil which flow through the Persian Gulf. One analyst told CBC this could see prices jump in increments of $10 per barrel.

Bank of England Governor told The Guardian such conflict could make it impossible to stabilise oil prices and cause an energy crisis akin to the 1970s. He told the newspaper: “My sense from all the conversations I have with counterparts in the region, is that there is, for the moment, a strong commitment to keep the market stable.” However, he insisted that there were limits to what could be done to prevent the cost of crude oil rising if things “got really bad”.

This left me wondering: Bad for who?

What do oil shocks do?

A common fear-grumbling among politicians and journalists is that oil production shocks will ripple through the market causing oil price shocks. These oil price shocks then ripple through the stock market, they insist, causing volatility. And, really, there’s nothing we can do about it, because the problem is the supply of the material commodity. Nobody can pull oil out of thin air. If there’s less going around, there’s less going around.

This argument looks airtight on paper. But it’s wrong. This is nothing more than intuition-generated soundbites. It’s vibes masquerading as financial policy. But you will see it repeated over and over and over again in the next few weeks as if it were backed up by data.

There is data—and the data says something different. Researching this article I read tens of academic papers on the relationship between oil price shocks and the stock market, and at least two referenced the dichotomous understandings of the relationship between oil and markets by both politicians/financiers and academics. The academics, those who crunch the data, are very clear that shocks to oil triggered on the supply side do not negatively impact the stock market both on the short and long term.

Oftentimes the impact is positive, as during COVID-19 or Russia’s invasion of Ukraine: “The overall results for the oil-stock returns show significant positive response of stock returns to oil returns during the Russian-Ukraine war period.”¹

These same researchers found that supply driven shocks have had “hardly any” impact on market volatility and that “supply shocks seem to have no role in explaining the surge in the price of oil in 2008”.²

“This fact is at odds with the view shared by the majority of policy makers and financial investors, according to which a direct causal link between volatility and political events in the Middle East is often postulated...”³

So why does the asset-owning class jump to attention when there’s a hint of threat to production? Because it makes the price jump: “All shocks have been normalized such that their expected effect is to generate an increase in the price of crude oil.”⁴

And when the price of oil jumps up, returns jump with it: “The outcome implies that returns on asset are usually realized in the high oil price period like the Russian-Ukraine war period.”⁵

Study after study showed that oil shocks triggered on the supply side do not harm the market. On the contrary, the price jump benefits the market’s overall returns. This is especially true for net oil-importing nations like the USA, Europe and the UK.⁶ This same model held true when looking at the effect of oil price shocks across African nations.⁷ It is oil-producing countries, those who depend on the material for large percentages of their revenue, who are most at risk of market shocks and volatility because their stock markets are more directly correlated with the price of crude oil.⁸

The real-world impact

This all makes sense, intuitively. We have all lived through an energy crisis and seen our bills spike while the stock market spiked with it. Much like oil is great for profits but bad for the planet, it’s great for the market but bad for people.

Yet, we were all labouring under the impression that said spike in bills was due to the market reacting to a genuine threat. Instead, people are dying all around the “developed” world from fuel poverty because the market and our governments see ghosts. Helpfully, they make a killing from it.

There is no threat on the supply side because, for now, there’s more than enough oil to go around. Remember, OPEC countries have been deliberately slashing production to artificially stimulate prices. And even if Iran’s infrastructure was taken out, the global supply would not be impacted: “OPEC+ has enough spare capacity to make up for the shock," Amrita Sen, co-founder of Energy Aspects, told Reuters.

Despite the total lack of material threat to oil supply and market, this is going to hurt. We are already victim to an array of media pieces manufacturing consent for another energy crisis in which we’ll see prices spike past the level some can afford—and it will be the fault of a foreign aggressor.

When you’re being price-gouged in the next energy crisis, remember the asset-owners are raking in the profits of panic that they not only let happen, but actively generated:

• $100 oil could be the October surprise no one wanted — CNN

• Oil market faces a rude awakening if Iran’s energy infrastructure is targeted, analysts say — CNBC

• Israeli strikes on Iran’s ‘oil island’ could send crude prices soaring — Market Watch

• Oil jumps over $3 a barrel as Middle East conflict stokes supply worry — Reuters

• Oil prices climb as Iran missile attack prompts supply fears — Financial Times

• The Economic Cost of a New War in the Middle East - An escalation of fighting between Israel and Iran could cause oil prices to spike and send a chill through the global economy. — New York Times

• “If Iran’s oil exports of around 1.8 million bpd were taken offline, prices would likely jump by at least $5 per barrel” — Bob McNally, president of Rapidan Energy, to CNBC.

• “Any further escalation in geopolitical tensions could push oil prices higher once again, complicating the global inflation outlook” — Euronews

1. Global oil price and stock markets in oil exporting and European countries: Evidence during the Covid-19 and the Russia-Ukraine war: https://www.sciencedirect.com/science/article/pii/S2590051X2400008X#s0055

2. How does stock market volatility react to oil price shocks? https://arxiv.org/pdf/1811.03820

3. How does stock market volatility react to oil price shocks? https://arxiv.org/pdf/1811.03820

4. How does stock market volatility react to oil price shocks? https://arxiv.org/pdf/1811.03820

5. Global oil price and stock markets in oil exporting and European countries: Evidence during the Covid-19 and the Russia-Ukraine war: https://www.sciencedirect.com/science/article/pii/S2590051X2400008X#s0055

6. Oil shocks and equity returns during bull and bear markets: The case of oil importing and exporting nations: https://www.sciencedirect.com/science/article/abs/pii/S0301420721004694

7. The effect of oil price shocks on stock market performance in selected African countries: https://onlinelibrary.wiley.com/doi/abs/10.1111/opec.12288

8. Shock transmission between crude oil prices and stock markets: https://www.sciencedirect.com/science/article/pii/S0301420723004658