On the brink? US-Iran tensions and their impact on oil, gold and equity markets

investment insights

On the brink? US-Iran tensions and their impact on oil, gold and equity markets

Sophie Chardon - Cross-Asset Strategist

Sophie Chardon

Cross-Asset Strategist
Samy Chaar - Chief Economist

Samy Chaar

Chief Economist
Bill Papadakis - Macro Strategist

Bill Papadakis

Macro Strategist

Key takeaways

  • Tensions between the US and Iran have heightened. However, we do not anticipate a deeper conflict, and we expect the confrontation to remain contained to the region.
  • Oil prices are pricing-in a significant geopolitical risk premium. In our central scenario, we maintain our 12-month target at USD 60/barrel. Oil demand will continue to depend on the slowing global economy.
  • In the event of an armed conflict, which remains a tail risk for now, oil could exceed 75 USD/barrel and gold 1,650 USD/ounce.
  • We expect more volatility in markets. Gold remains the most effective portfolio hedge against geopolitical uncertainty.

Tensions between the United States and Iran have intensified in the last few days following an American airstrike on Bagdad airport ordered by President Trump that killed Iranian commander Qassem Soleimani. The Iranian authorities retaliated on 7 January. Although financial markets are used to the geopolitical risk emanating from the region, this marks a clear intensification that warrants a close eye.

Taking a step back, we see the Middle East turmoil of the last fifteen years (wars in Iraq, Syria, Yemen) as the result of a profound change in the region’s balance of power. The forty-year domination of the Sunnis (under the leadership of first Egypt, then of US-backed Saudi Arabia) is gradually giving way to a confrontation between communities, in which the Shiite bloc is returning to the fore under Iranian leadership (in parts of Lebanon, Yemen, Iraq and Syria) with support from Russia and at times China.

The Middle East turmoil of the last fifteen years is the result of a profound change in the region’s balance of power

In this environment, Europe is seeking to maintain a relatively neutral stance and to serve as mediator – particularly in favour of a return to the Iran nuclear deal. While the confrontation between the two blocs will continue in the medium term, it should remain contained to the region – as it has done so far in spite of the multitude of conflicts. In fact, fifteen years of conflict and instability in the Middle East have not spawned instability elsewhere in the world, and the oil price has been contained in spite of occasional volatility episodes.

While the confrontation will continue in the medium term, it should remain contained to the region – as it has done so far in spite of the multitude of conflicts.

Impact on the oil price: On Friday, 3 January 2020, the oil price rose by 3.5% to USD 68.5/barrel (Brent). As we write, it is still trading at around this level. However, while we judge the risk premium to be justified by recent events, we think it will prove short-lived.

In fact, this is precisely what the oil market, which is used to geopolitical uncertainty (chart 1), is pricing-in. Oil futures curves are now very steep (chart 2) as the longer part has moved up only modestly (December 2022 futures have risen less than USD 1/barrel since the beginning of the year). This suggests the following:

  • While spot prices carry a geopolitical risk premium, it has not spread along time maturities in a significant way
  • Because of the steep backwardation, future prices are not attractive enough to incentivise US exploration and production (E&P) companies to hedge their production and/or to increase activity.

Going forward, although the heightened tensions might lead to destruction of production capacity in the region, it is important to recall that:

  1. Iran is currently under sanctions, and its production is already close to historical lows.
  2. Markets were expecting surplus oil supply in the first quarter 2020 due to the arrival on the market of new conventional programmes – in the North Sea, Guyana, and Brazil.
  3. OPEC announced in December 2019 that it would again lower production to counter the surplus supply.

For these reasons, and especially after the latest OPEC production cuts, any potential disruption would have to be substantial and protracted to lead to a prolonged deficit, and, subsequently, a sustained rise in oil prices.

We maintain our 12-month forecast for the oil price at USD 60/barrel

Like in September 2019 following the attacks on Saudi facilities, this has prompted us to maintain our twelve-month forecast for the oil price at USD 60/barrel (Brent). We believe the main driver will be the slowing global economy and its effect on oil demand.

In our view, the major risk lies with the Iranian regime, should it decide to close the Strait of Hormuz through which transits nearly 30% of the world’s oil trade. Such a scenario could support oil prices above USD 75/barrel, but this should remain a tail risk.

The major risk lies with the Iranian regime if it decides to close the Strait of Hormuz through which transits nearly 30% of the world’s oil trade. This would support oil prices above USD 75/barrel.

From a macroeconomic standpoint, it is worth noting that risks from a prolonged oil price spike are more limited today than in the past, given the rise of the US shale oil industry. In addition, the Fed’s recent pivot towards greater tolerance of inflation overshoots should limit the risk of a monetary policy overreaction.

Impact on equity markets: Fears related to a possible armed conflict are weighing on investor sentiment, which explains the current equity market consolidation after the strong December run. Nonetheless, as long as the oil price does not reach levels that could derail the manufacturing sector’s sluggish recovery of the past few months, the impact on equity markets should prove limited. What could be affected – at least temporarily – is the relative performance of geographical regions and sectors (US markets tend to outperform in risk-averse environments and the energy sector benefits from higher oil prices).

In a scenario where armed conflict becomes reality, the result would be greater volatility and a more marked drop in equity markets. In the past, equity markets experienced losses of between 0 and -16%, like in August 1990 (table 1). Today, however, a 135% rise in oil prices appears highly unlikely. In order to counter this potential risk, we began implementing options strategies (puts, put spreads) several quarters ago.

Today, gold represents the better form of protection.

Impact on safe-haven instruments: Sovereign bonds and gold naturally benefit from the current situation. Historically, gold has proven a better hedge than sovereign bonds as the latter can be affected by the rise in inflation expectations implied by higher oil prices. Today, given the context of negative rates in the eurozone and Switzerland, which limits the hedging capacity of their government bonds, gold represents the better form of protection, and should be sustained at its current levels. In case of escalation to an armed conflict, gold could reach USD 1,650/ounce. Its hedging capacity underpins the increase in our gold exposure implemented in January 2019 to 3% at present across all profiles.

Important information

This document is issued by Bank Lombard Odier & Co Ltd or an entity of the Group (hereinafter “Lombard Odier”). It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful, nor is it aimed at any person or entity to whom it would be unlawful to address such a document. This document was not prepared by the Financial Research Department of Lombard Odier.

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