President Donald Trump, in his address to the nation Wednesday evening, caught oil markets flat-footed. Rather than signaling an early end to the Iran war, Trump said that the U.S. military would intensify its campaign against Iran for the next two to three weeks. Borrowing rhetoric from the Cold War, Trump said that the United States would “bomb Iran back to the Stone Age.”
Oil prices, both West Texas Intermediate, the U.S. benchmark, and Brent crude, the global price, surged. On Thursday, WTI was trading at around $112 a barrel. Trump’s words shifted market expectations about the outlook for oil over the next several months. Prices will be higher than expected, and America’s drivers will be paying over $4.00 a gallon for gasoline well into the summer. Economic growth will slow, but recession risk will remain low.
A few weeks ago, I wrote two pieces expressing optimism that domestic oil prices would normalize within a few weeks because, before the bombs started to fall, the global economy was well supplied with oil, and both the U.S. and China had large strategic reserves. But I did not anticipate that oil flows through the Strait of Hormuz would be substantially reduced for an extended period.
For oil prices to fall to prewar levels, the strait has to be reopened completely. Prior to the war, around 20 million barrels a day flowed through the narrow body of water, approximately 20% of global supply. But the president, in his address, offered no concrete timeline for reopening the strait. The uncertainty surrounding the strait is the major obstacle to lower prices.
Oil exports from Saudi Arabia, the United Arab Emirates, and Iraq are being shifted from transiting the strait to existing pipelines, but that reduces the supply shortfall by only around 8 million barrels a day. And the Iranian regime is allowing limited oil exports through the strait to countries it considers not aligned with the U.S. Still, the global supply of oil has been reduced by up to 10 million barrels a day. That is an enormous supply shock for an energy source with low demand elasticity. High prices only reduce demand marginally. Limiting the flow of oil through the strait has an outsize effect on price.
Until the strait is completely open, oil prices, both domestically and internationally, will remain very high, perhaps as high as $120 a barrel for WTI and even higher for Brent. Oil prices are set globally. U.S. production will flow to the highest prices.
But I do not expect oil prices to remain very elevated beyond July. High prices will force oil-importing nations to either form a military coalition to open the strait or pay tribute to the Iranian regime to ensure sufficient supplies of oil. By the end of the summer, the price of WTI should fall back toward $80 a barrel from the current price of $112 a barrel.
High prices will also trigger a supply response. U.S. shale producers have the ability to ramp up production faster than conventional producers. At $112 oil, drilling activity will accelerate. That response will not be immediate, but it will happen. There is also the demand side, which markets tend to underestimate during geopolitical crises. Sustained oil prices above $100 act as a tax on consumption. Europe, already economically fragile, is particularly exposed. Economists are warning that a prolonged supply disruption could tip countries in Europe into recession. Demand for oil would fall. High oil prices have a way of putting a ceiling on prices.
In plain terms, the current spike in oil prices is driven by fear, not fundamentals. Over time, fear dissipates, and market fundamentals determine prices.
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The U.S. sits in a uniquely strong position in this environment. The president emphasized that America is largely energy independent, a point that markets sometimes overlook. While global prices still affect domestic consumers, the U.S. is now a major producer and exporter of both crude oil and liquefied natural gas. That changes the economic impact of oil shocks. The U.S. benefits from higher energy revenues, increased drilling, and stronger capital investment in the energy sector.
But volatility in oil prices is here to stay. In this price environment, U.S. oil and natural gas equities will be attractive long-term investments.
James Rogan is a former U.S. foreign service officer who later worked in law and finance for over 30 years. Now he writes a daily note on markets, economics, politics, and social issues.