The oil markets are bracing for a jolt this morning after Tehran issued a stark warning: no US-Iran deal is imminent. For those who had been pricing in a diplomatic thaw, this is a cold shower. The Iranian foreign ministry, in a carefully worded statement, made it clear that negotiations remain at an impasse, dousing any flicker of optimism that had crept into the barrel price over the past fortnight.
Let us not mince words. The global oil supply chain is already stretched thinner than a budget airlines balance sheet. With OPEC+ production cuts still biting and geopolitical risk premium baked into every trade, the prospect of continued Iranian sanctions means roughly 1.5 million barrels per day of potential supply remain locked out of the market. That is a hole that cannot easily be plugged, even with the US Strategic Petroleum Reserve looking increasingly depleted.
The market's reaction was swift. Brent crude spiked above $92 a barrel in early Asian trading, a level not seen since October last year. The move was exacerbated by short-covering from hedge funds that had been betting on a diplomatic breakthrough. Now they are scrambling, and that creates its own volatility. The VIX of the oil market, if you will, is flashing amber.
But let us step back and consider the fundamentals. This is not a demand-side shock. The global economy is spluttering, with Chinese GDP growth undershooting expectations and European manufacturing in contraction territory. Yet supply constraints are trumping macroeconomic weakness. It is a classic case of inelastic demand colliding with artificially constrained supply. The cure for high oil prices is high oil prices, as the old adage goes, but that cure takes time. In the short term, we are looking at a crudeflation risk that will feed into headline inflation figures across the developed world.
For the Bank of England and the Federal Reserve, this could not come at a worse time. They are already grappling with sticky services inflation and a labour market that refuses to cool. A sustained rise in energy costs will complicate their tightening cycles, potentially forcing them to keep rates higher for longer. That is a headwind for equities and a tailwind for gilt yields, which have already been creeping up. I would not be surprised to see the 10-year gilt yield test 4.5% again if oil stays above $90.
Capital flight is another concern. Emerging markets that are net oil importers, such as India and Turkey, will feel the squeeze. Their currencies will weaken, forcing their central banks to hike rates or risk capital outflows. The dollar, as ever, will be the beneficiary, but that only tightens global financial conditions further. It is a vicious cycle that the IMF has warned about repeatedly.
The political calculus in Washington is equally fraught. With an election looming, the Biden administration has little appetite for higher petrol prices. But the Iran hawks in Congress will block any meaningful concessions, and Tehran, for its part, seems content to wait out the Americans. The result is a stalemate that keeps the oil market on edge.
What should investors do? Diversify away from risk assets exposed to energy cost inflation. It sounds trite, but it is sound advice. And watch the weekly EIA inventories like a hawk. Any drawdown below the five-year average will be taken as a signal that the supply-demand balance is even tighter than feared.
In summary, today's news from Tehran is a reminder that geopolitical risk is never fully priced in. The oil market is a cruel mistress, and she is not in a forgiving mood.
