Why are oil prices rallying so much?
The most obvious explanation is that the recent assassination of Iranian General Soleimani raises the probability of all-out war in the Middle East. More precisely, the threats of an Iranian response, followed by Trump’s even more worrying threats of a response to the Iranian response mean that the situation risks getting out of control, with escalation after escalation leading to a full-blown conflict.
Why does that raise oil prices?
A large percentage of global oil reserves are located within a concentrated area in the Middle East, i.e. in Saudi Arabia, Iran, Iraq and the Gulf states. Oil facilities in all these countries risk being destroyed in a war. Moreover, just off the south coast of Iran in the Strait of Hormuz, a waterway through which 20% of global oil supply passes. As we know, lower supply tends to drive prices higher - a Middle Eastern war would severely restrict oil supply, likely lead to global shortages and would drive prices significantly higher. Traders, who anticipate the possibility of a significant rise in prices, front-run such events in order to get ahead of the market. That is why we have seen prices rally so much despite not a single drop of supply being affected yet since the assassination.
However, most understand that the risk of full-scale war is low. Iran knows that it could inflict significant harm on the global economy through higher oil prices, and on the US and its allies through large scale cyber-attacks and with its decent army. But they know that they are outgunned and would ultimately lose, likely resulting in regime change and the deaths of large numbers of Iranian civilians. Indeed, an Iranian official over the weekend said that no war can be expected (although Iran is prepared for all eventualities).
Although Trump has been talking a big game in recent days, which has certainly spooked markets (look at equities), he has a history of backing down, even at the last minute. Remember, last year he called off Iranian airstrikes when fighter jets were already in the air! Moreover, look at the much tamer US response to recent provocations from North Korea; the latter have been threatening to walk away from international missile testing agreements, have been talking about an imminent attack on their enemies (US & South Korea), have been talking about unveiling new weapons. All Trump has said is that he does not believe North Korean Leader Kim Jong Un will break his word. Admittedly, other US officials have spoken of how US forces are ready for a North Korean attack, which did slightly spook markets at the time but that is beside the point.
Trump has an election coming up. He wants to be seen as the deal-maker (US/China Phase 1 deal and his now failing deal with North Korea) and the peacemaker who brings US troops home; a large part of his election pledge was to get the US out of endless wars. Personally, I doubt it is in his interests to start a massive war in Iran ahead of an election, a war that would undoubtedly be highly unpopular back home.
So yes, war risk is supporting oil prices. But there is another, less obvious, but equally, important factor to note. In sum, Iraq looks as though it is about to fall into the hands of Iran, Russia and China, which means that Iraq could be hit with the same sanction on oil exports as Iran, which means 3.5mln BPD of Iraqi oil exports at risk.
Very simple Middle Eastern geopolitical explainer
Since the discovery of oil in the Middle East in the 19th century, and the associated wealth control over these resources can bring, the Middle East has been an important focus of global super-powers. In the past, it has been the British Empire vs the Russians vying for influence. The US then largely replaced the British and battled for influence with the USSR. Now the picture is pretty much NATO, or the West (US, UK, EU, Canada, Australia etc.), vs the rest, which is basically Russia and China, who have loosely been becoming closer in recent years to counter global US influence.
Meanwhile, a very different, much older contest is playing out in the Middle East; the Sunni vs Shia conflict. For those who don’t know; both are different sects, or versions, of Islam and have been in conflict for over 1000 years. Comparisons could be drawn to the way Christianity is split largely between Catholicism and Protestantism, although the conflict within Islam is much older. Iran is Shia and is seeking to bolster the influence of its version of its religion within the Middle East. Saudi Arabia is Sunni and its seeking to bolster its version of Islam.
The two nations are essentially involved in a number of proxy wars across the region, including in Yemen (the Houthi Rebels who sometimes attack Saudi Arabia are backed Shia and backed by Iran). Essentially, the US (and by extension NATO) backs the Saudi’s, and therefore is more on the Sunni side (although ISIS were Sunni, so it is not a blank statement), while other powers such are Russia, and now possibly China too, are more closely aligned with Iran.
So how does this all relate to Iraq? The Iraqi Muslim population (roughly 98% of the country) is roughly 2/3 Shia, 1/3 Sunni. Since the toppling of Saddam Hussein’s government back in the early 2000s, Iran has sought to increase its influence in Iraq. Several Shia militias backed by Iran currently operate in Iraq; these were responsible for the recent besieging of the US embassy and are the primary suspects behind the weekend’s missile launches.
They, like the Shia population in general, are sympathetic to Iran. Up until now the presence of the US in Iraq has kept the Iraqi Shias out of control. But, with the Iraqi parliament voting to kick out US troops over the weekend, it is becoming more likely that the Shias will gain power, and with that, Iraq will reorient towards Iran away from the US and the West.
Should Iraq orient itself more closely with Iran, it is likely to come to loggerheads with the US; Trump has already threatened severe sanction akin to those currently on Iran should US troops receive the boot. Iran is essentially banned from exporting oil by the US, which severely restricted its output. It is not inconceivable to think that Iraq could receive the same treatment.
Although war is a very real possibility, it seems to me that a reorientation of Iraq away from the US and towards Iran is the much more likely outcome here.