Scenarios for Israel-Iran War, How much does oil still matter?

By Elliot Hentov, Head of Macro Policy Research at State Street Global Advisors.

Markets have largely discounted escalation risk stemming from current Israel-Iran war. Global macro transmission indeed requires an unlikely series of events. Albeit low, those risks are not diminishing but stable. In the tail risk scenario of oil supply shock, a temporary respite of the positive oil-dollar correlation would partially cushion the impact of any spike in oil prices.

In April 2024, we had flagged that the precedent of the first Israel-Iran missile exchange dramatically increased the chances of a full-fledged Israeli attack on Iran. While this week’s event itself was not a surprise, the timing certainly was and due to an elaborate deception, markets (and Iran’s leaders) were initially jolted by the news on Friday. A few days of mutual air warfare has given markets the comfort that global energy markets will be largely unaffected. Since airstrikes began, Brent oil sits about +6% but is roughly flat YTD. That’s a small risk premium given that about 1/5 of global hydrocarbons transits the Straits of Hormuz. By and large, we would nonetheless share this assessment, though do not consider risks as having declined since Friday. Table 1 here summarises our views:

One also needs to place the potential oil shock in context: while global oil intensity (i.e. oil barrels per unit of GDP) has dropped 50-60% since the 1973 oil shock, America’s recent transformation into a net oil exporter flipped the historical negative correlation of oil prices and US Dollars. So in the past, higher oil prices were slightly offset by a weaker USD and vice versa. This buffered extreme price swings whereas since 2019, oil price movements and the USD were positively correlated. In essence, this makes oil price swings much more pro-cyclical for global monetary conditions. It can also therefore make oil shocks worse. Fig.1 illustrates the magnitude of the shift.

However, in recent weeks, that correlation appears to have suddenly flipped back again on the back of a shift in the overall risk premium attached to the USD. Fig. 2 is from GM’s charts of the week today, suggesting that this effect would now again be somewhat less pronounced.