The escalation of conflict in the Middle East once again raises the question—amid expectations of supply chain disruptions due to the complex geopolitical relationships in this oil-rich region—of how the current events will impact oil prices, financial markets, inflation, and global economic stability.

As Israeli forces have intensified their military presence in Lebanon, and Iranian missile attacks targeted Israel, oil prices surged by around four percent, reaching nearly $75 per barrel. This market reaction highlights investors’ sensitivity to geopolitical events in a region critical to global energy supply. However, despite the recent tensions, financial markets have shown surprising resilience, as the MSCI Global Equity Index has slipped by only one percent below its record highs, reflecting a relative calm among investors.

Resilience Despite Tensions

There are several reasons for this unexpected stability, primarily due to the prevailing belief that diplomatic channels could help de-escalate the current conflicts. There is cautious optimism that the recent surge in violence could be reduced, especially considering the high stakes involved in the conflict. Moreover, oil prices had already been on a downward trend, falling more than 10% prior to the recent attacks, which softened the impact of the price increase after the attacks occurred.

Additionally, the VIX volatility index, often referred to as the “fear index” on Wall Street, remained moderate at 18.7 at the time of writing, just surpassing 20 on Thursday, significantly lower than the post-pandemic peak above 60 during previous market turmoil. This stability in the VIX suggests that investors, for now, are adopting a cautious approach to the situation in the Middle East.

At the heart of any discussion about oil supply and Middle Eastern geopolitics is the Strait of Hormuz, a narrow waterway through which about 20 million barrels of oil pass daily, accounting for nearly 30% of the world’s seaborne oil trade. This critical point connects oil-rich Gulf states like Saudi Arabia, Iraq, and the UAE with global markets. A significant portion of the oil transported through the strait is destined for Asian markets, particularly China, India, and Japan, which are among the largest consumers of Middle Eastern oil.

Given its strategic significance, the Strait of Hormuz remains vulnerable to disruptions caused by geopolitical tensions. If Iran were to take aggressive actions disrupting maritime traffic in the area—such as threatening to close the strait or targeting oil tankers—the consequences could be severe. According to the International Energy Agency (IEA), any major disruption to oil flows through the strait could lead to significant increases in oil prices, with recent forecasts suggesting that a barrel could cost up to $100 or more in the event of a prolonged crisis.

Potential Israeli strikes on Iranian oil infrastructure, as noted by the New York Times, raise further questions about the implications of such actions on regional stability. There are concerns that Iranian retaliatory actions could deepen the crisis, leading to a broader conflict that further jeopardizes global oil supplies. Such a scenario would not only impact oil prices but also other trade routes critical to the health of the global economy.

The U.S. and Rising Oil Production

One of the most significant developments in this area since the beginning of the century has been the positioning of the United States as a dominant player in global oil production. According to EIA data, the U.S. has consistently maintained its status as the world’s largest oil producer, holding this position for over six years. This evolution in production capacity has significantly changed the global energy market landscape and reduced dependence on Middle Eastern oil.

The U.S. has bolstered its crude oil reserves, reaching historically high levels, providing a key buffer against the negative effects of potential oil supply disruptions due to geopolitical tensions in the Middle East. Moreover, the U.S.’s growing ability to produce shale oil has made the country less vulnerable to price fluctuations caused by Middle Eastern conflicts. For example, in October 2023, U.S. crude oil production averaged around 12.9 million barrels per day, significantly contributing to global supply and offering reassurance to investors concerned about disruptions in Middle Eastern oil supply.

According to the IEA, OPEC+ members—which include oil-exporting countries and their allies, including key players like Saudi Arabia and Russia—can adjust their production levels to stabilize the market. This means that even if Iran’s oil exports were reduced due to the conflict, other producers could increase their output to fill the gap. While Iran’s production is significant, averaging around three million barrels per day, the IEA emphasizes that this represents only about three percent of global supply, making it easier for other producers to offset potential losses.

Iran’s Role and Potential Consequences

Although current market reactions to geopolitical tensions have garnered attention, it is essential to place these developments in a broader economic context and consider the possible consequences for global economic growth and inflation. Oxford Economics estimates that if oil prices were to rise to $130 per barrel due to an escalation of the conflict, global production growth could decrease by as much as 0.4 percentage points, which is a cause for concern given the International Monetary Fund’s recent forecast that global economic growth is expected to be 3.3 percent next year.

The potential for rising oil prices is particularly pronounced in regions with limited domestic oil production, such as Europe. Unlike the U.S., European countries remain highly dependent on oil imports, making them vulnerable to any sharp increase in prices triggered by conflicts in the Middle East. Europe’s energy markets, as noted by the New York Times, face unique challenges due to their dependence on imported oil and gas, especially in light of the ongoing conflict in Ukraine, which has further complicated energy security in the region.

Decision-makers in the most developed countries of the European Union are aware that even a moderate increase in oil prices, estimated at around 10%, could lead to higher inflation rates. Central banks may find themselves in a challenging position, as rising energy costs could undermine their efforts to stabilize prices and promote economic growth. The Bank of England has signaled its commitment to closely monitoring inflation trends, stating in its latest report that a sustained increase in prices could lead to more aggressive interest rate cuts in an attempt to alleviate inflationary pressures.

The role of central banks in navigating the complexities of geopolitical tensions and oil price fluctuations is crucial. Recent statements from various central bank officials emphasize the need to consider both immediate shocks and long-term economic trends. For instance, Bank of England Governor Andrew Bailey recently noted that, while the ongoing conflict in the Middle East poses risks to economic stability, it does not currently necessitate drastic changes in monetary policy.

Today’s economic landscape is significantly different from that seen during Russia’s invasion of Ukraine in 2022, when central banks were forced to tighten monetary policy aggressively in response to soaring inflation. In contrast, many central banks are now in a loosening phase, creating an environment conducive to economic growth. As a result, there is growing optimism that the U.S. economy might avoid a recession, which, coupled with declining inflation, provides an additional buffer against the impact of Middle Eastern developments.

Balancing Inflation and Stability

It is also important to consider the phase of the economic cycle. According to Royal London Asset Management, the global economy is currently in a “softer phase,” making it less susceptible to shocks caused by rising oil prices. This contrasts with previous crises when inflation was already climbing, allowing for greater flexibility in monetary policy responses.

Geopolitical dynamics play a key role in shaping market sentiment and investor behavior. As tensions rise, risk perception can significantly influence market movements. As mentioned earlier, the VIX index serves as a measure of market fear and uncertainty. Its rise typically signals increased market volatility and concerns over potential losses, while a lower VIX indicates investor confidence.

At this stage, however, the VIX remains at moderate levels, reflecting a relatively calm market environment despite geopolitical tensions. This stability can be attributed to the underlying strength of the U.S. economy and the ability of other oil-producing countries to adjust their output in response to market dynamics. Nevertheless, market participants remain vigilant, carefully monitoring developments in the Middle East and any signs of escalation that could affect supply chains.

If there were a sharper increase in oil prices than what has been observed this week, it could directly lead to higher costs for businesses and consumers worldwide, potentially triggering inflationary pressures that could influence central bank decisions. Therefore, developments in the Middle East present significant challenges for global oil markets and the broader economy. Although rising oil prices are a cause for concern, current market dynamics and structural changes in oil production offer some degree of resilience against potential shocks. However, while Iran’s oil production accounts for only 3% of global supply, transport through the Strait of Hormuz remains a crucial determining factor in the global supply chain.

A Montenegrin version of this article is available on the Antena M portal.