Iran: What Next?

Brent crude is trading around $80/bbl, compared with an estimated fair value of approximately $64/bbl based on underlying fundamentals. This implies a risk premium of roughly $16/bbl. Importantly, there have been no confirmed outages to flowing production – as such, the premium reflects supply risk, not realized supply loss.

Three key risk channels were identified:

1. Disruption to Iranian exports (approximately 1.3–1.4mn b/d, largely flowing to China).
2. Strikes on regional energy infrastructure.
3. A sustained blockage of the Strait of Hormuz, through which roughly 20mn b/d of crude and oil products transit.

While a full closure of the Strait of Hormuz would represent a severe tail risk, it is viewed as a low-probability scenario. Given the strategic importance of the route, a broad naval coalition would likely be assembled to ensure continued transit. In addition, domestic economic incentives within Iran and the importance of oil revenues reduce the likelihood of a prolonged shutdown.

Absent a physical outage, oil prices are expected to maintain an elevated premium but not move materially higher. In the event of sustained infrastructure disruption or transit blockage, prices could rise toward or above $100/bbl. In such a scenario, strategic petroleum reserves would likely be deployed to prevent uncontrolled price escalation.

Market moves have been more pronounced outside crude oil. European diesel cracks have widened sharply, reflecting import vulnerability following reduced Russian supply and refinery closures in recent years. Even limited strikes on regional refining assets highlight Europe’s sensitivity to Middle Eastern distillate flows.

European natural gas has also rallied significantly. Particular attention has focused on LNG infrastructure in the region. Unlike oil, there is no meaningful global strategic gas reserve mechanism. In a severe disruption scenario involving Qatari LNG volumes, prices would need to rise substantially to force demand destruction, potentially revisiting levels at which fuel-switching and industrial curtailment occur.

In contrast, U.S. natural gas markets remain relatively insulated from Middle Eastern supply risk. However, indirect effects are possible. If higher oil prices incentivize increased oil-directed drilling, associated gas production could rise, potentially tempering U.S. gas prices over the medium term. Current market balances suggest a level near $4/MMBtu is needed to incentivize dry gas production in key basins; additional associated supply could lower that threshold.

For Asia, duration is the key variable.

China is significantly dependent on Middle Eastern oil, and Iran has been an important supplier. Strategic reserves could cushion short-term disruptions. However, this event builds on earlier supply uncertainties and may complicate long-term diversification strategies, including infrastructure projects designed to mitigate maritime chokepoint risk.

Japan and South Korea are even more exposed to flows through the Strait of Hormuz, with Japan’s dependency particularly high relative to regional peers. While this could weigh on growth and markets in the near term, it may also justify additional fiscal or security-related spending domestically.

In financial terms, direct exposure of large Chinese banks to Iranian energy trade appears limited. Smaller regional institutions involved in trade finance could face more concentrated risk. Indirect exposure via large-scale construction projects in the Middle East – particularly in the Gulf – may represent a more material transmission channel if projects are delayed or financing conditions tighten. At the same time, higher oil prices could support fiscal capacity in producing countries, partially offsetting these risks.

Geopolitically, the situation may influence perceptions of diplomatic alignment and security guarantees across the region. The broader implications will depend heavily on how events evolve.

In the U.S., the primary near-term concern is inflation.

Federal Reserve models typically assume that a USD 10 increase in oil prices adds roughly 20–40 basis points to headline inflation, with limited sustained impact on core inflation. Energy shocks are often viewed as temporary and potentially contractionary, acting as a tax on consumers.

However, today’s macroeconomic context differs from the pre-pandemic era. Supply chains are less optimized, fiscal deficits remain elevated – approximately 6% of GDP even at full employment – and the transmission of shocks may be less predictable.

If energy prices remain elevated, consumer spending could soften given households’ higher marginal propensity to consume relative to energy producers. That dynamic could eventually prompt discussion of targeted fiscal support, although political constraints remain significant.

Regarding monetary policy, institutional and legal safeguards are expected to preserve Federal Reserve independence. Nevertheless, markets may still price in perceived risks around policy direction, particularly in a politically sensitive environment. Even if formal independence remains intact, concerns about fiscal sustainability and political pressure can influence term premia and front-end rate expectations.

From a rates perspective, even a temporary shock may alter market pricing. In prior cycles, geopolitical events were often viewed as disinflationary. In the post-COVID environment – characterized by tighter supply chains and greater structural fragility – shocks may carry a more inflationary interpretation.

In a base case of contained but persistent tension, front-end yields could decline modestly on growth concerns, while longer maturities reflect elevated term premium. The result could be a steeper yield curve rather than a broad-based collapse in rates.

While comparisons to 2022 are understandable, key differences remain. Supply chains are largely normalized, and global inventories, particularly in oil, provide some buffer. A repeat of the broad-based global inflation surge seen in 2022 is not the base case. However, tail risks linked to transit disruption or sustained LNG outages would materially change that outlook.