John Kemp

War Risk Premium Adds Only $10 to Oil Prices

U.S./Iran: Oil Prices and the War Risk Premium Oil traders currently assign a low probability to a war between the United States and Iran that results in significant and sustained disruption to exports from Iran and other countries in the Persian Gulf. Front-month Brent futures were trading around $60 per barrel in January before the United States started to mass warships and aircraft in the Middle East and the Indian Ocean and ramped up threats against Iran. Since then, front-month futures prices have risen to just over $70, suggesting the war risk premium is approximately $10. The relatively small increase so far implies either traders believe the probability of disruption is low or the impact would be minor (or some combination of both). The chart below shows various combinations of probability and impact consistent with the current observed price of between $70 and $75. If traders assume the impact in the event of a full-scale war would be large (adding more than $50 per barrel) then the expected probability is low (65%) then the assumed impact is relatively modest (adding $20 or less). There are various explanations for the relatively small war premium currently embedded in oil prices - which are not exclusive: a)The United States and Iran reach a last-minute agreement averting war. b)The United States and Iran fight a limited war of short duration avoiding damage to oil infrastructure. c)The United States initiates a major conflict but spares Iran’s export installations and tanker traffic. d)Iran’s response is limited to avoid escalation and avoids damaging third-country export installations and tanker traffic. e)Iran attempts to escalate by hitting oil third-country oil installations and tanker traffic, but the threat is effectively suppressed by U.S. missile defences, air superiority and warships ensuring oil exports continue. f)Iran is able to close the Strait of Hormuz to tanker traffic briefly, but the waterway is quickly re-opened by the United States using air power to suppress shore-based threats and naval escorts to convoy tankers safely. g)The United States and Iran fight an unrestricted war, resulting in a sharp drop in oil flows from the Gulf, but the duration is short, measured in days or a few weeks, resulting in a minor loss of oil exports overall. h)The United States and Iran fight an unrestricted war resulting in Iran’s capitulation, regime change, or a rapid ceasefire if the costs prove intolerably high for either government. i)The United States and other members of the International Energy Agency release oil from the Strategic Petroleum Reserve (SPR) and other strategic stocks to offset any interruption of exports from the Gulf. j)China releases crude from its own strategic reserves to limit the impact of shortages and price rises on its domestic refiners and consumers.