Oil markets have a China question

While attention is focussed on the Strait of Hormuz, China’s demand for crude oil may prove key for prices this summer. We look at changes to the energy market in response to the Middle East conflict, and how price dynamics could evolve from here.

Two weeks after the US and Iran’s memorandum of understanding, Brent crude oil prices have retreated close to pre-conflict levels, at just over USD 70/barrel. The reopening of the Strait of Hormuz is proceeding broadly in line with our expectations, as prior flows slowly return. Stranded ships are exiting the waterway, although mine clearing the main channels may take several more weeks, as will the recovery of pre-war tanker traffic.

Crucially, without major structural damage to oil infrastructure, many producers in the region can quickly resume pumping. Saudi Arabia and the United Arab Emirates had a combined 2-3 million barrels per day of spare capacity pre-conflict, and we expect their output to ramp up within weeks as more tanker capacity becomes available. We also expect the return of Iranian and Iraqi supplies within the coming months.

Back to an oil glut?

Concerns about an imminent oil glut have replaced fears of shortages at the height of Middle East hostilities. Before the conflict began in February, the global oil market was in surplus. Today, a swift return of production threatens to coincide with lower demand, as countries have found workarounds to reduce their oil reliance.

Concerns about an imminent oil glut have replaced fears of shortages at the height of Middle East hostilities

We think the reality could be more nuanced, and in coming months, much will depend on China’s actions. During the conflict, the world’s second biggest economy cut oil imports by around 5 million barrels per day. Economic activity slowed markedly in April and May. 

China had been building oil inventories in the months and years pre-conflict, and is thought to have relied heavily on consumption shifts and petroleum export controls to retain this geopolitical risk buffer. However, while data on US oil reserves is plentiful, data on Chinese reserves is not.

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The short-term trajectory of oil prices now depends less on the mechanics of an open Strait of Hormuz and more on Chinese demand. If the country begins ramping up imports with prices at current levels or higher, it will signal that the economy needs to replenish its inventories and that could see the oil price climb well above USD 80/barrel in coming months. But if China is not seen entering the market, traders will conclude that its demand flexibility is real and oil prices could fall further from here.

The short-term trajectory of oil prices now depends less on the mechanics of an open Strait of Hormuz and more on Chinese demand

More elastic oil demand

The longer-term repercussions of the conflict on energy markets will be profound. The first, and most important lesson we can draw is that oil demand is much more elastic than previously assumed. To be clear, much of the impact of this energy shock was absorbed by major developed economies drawing on ample oil reserves. The rapid depletion of US reserves, just as the country was about to enter its holiday driving season, likely influenced the push to strike a deal with Iran. 

But individual and industry behaviour was also able to adapt: the former on switching transport options, remote working, or using electric rather than oil-fired stoves in some emerging markets. Shipping and aviation slowed globally, and the petrochemical industry switched from using oil to natural gas to make plastics, helped by the current overcapacity in the chemicals industry. We calculate that perhaps 5% of global oil demand may have been curtailed by the conflict, and not all of that will return. Some flexibility is visible in pricing, too. Saudi Arabia this week cut its official selling price by the most in six years. That means Saudi Aramco, the world's biggest oil corporation, has reversed the increase imposed at the start of the conflict, and now offers its crude at a slight discount to international benchmark prices. 

Oil demand is much more elastic than previously assumed

The second, related, lesson is that it may now take a huge shock to drive Brent crude oil prices above USD 100 per barrel. Before the conflict, economists modelling a major energy shock might have assumed oil would peak at USD 150/barrel or higher. But while the International Energy Agency warned that this conflict threatened the “largest energy crisis in history”, the macroeconomic impacts have so far proved manageable. They have justified both our own forecasts of oil prices averaging USD 90/barrel for the six months since the start of the conflict, and our expectation of a limited impact on growth and core inflation across major economies.

Reducing reliance on Hormuz

The third conclusion we can draw is that Iran’s use of the Strait of Hormuz as a weapon of economic warfare will speed global efforts to diversify away from it. Currently, the threat of Iranian attacks, transit restrictions, or tolls in the Strait has built perhaps a few dollars’ premium into the global oil price. However, as Russia found from 2022 onwards, its own weaponisation of energy supplies – in this case cutting piped natural gas supplies to Europe – has become less effective over time.

Globally, the threat hanging over the Strait of Hormuz will push countries to invest more in energy security, alternative supplies and renewable energy sources. During the conflict, Saudi Arabia increased flows through its East-West pipeline to capacity. The UAE has been running above maximum capacity through its bypass route through Fujairah, and has expressed a desire to have zero dependence on the Strait in future, which will require major infrastructure investment. Higher oil prices have given incentives for other producers, namely in the US shale industry, Argentina and Brazil, to maximise output, although their short-term flexibility is limited.

OPEC in decline

The conflict also implies a further loss of influence for the oil cartel, the Organization of the Petroleum Exporting Countries (OPEC), which could in turn make prices more volatile. The UAE’s exit from OPEC on 1 May 2026 potentially adds 1% to global oil supply short-term and a further 1-2% by 2030. Iraq is now pushing OPEC to raise its own production quotas. A weaker OPEC reduces Saud Arabia’s incentive to show supply restraint and producers may be tempted to launch price wars to gain market share. Meanwhile, ex-OPEC oil supply is rising fast, with new projects planned in the US, Guyana and Brazil.

The conflict implies a further loss of influence for OPEC, which could in turn make prices more volatile

Yet just as oil prices did not reach the most catastrophic predictions during the conflict, we see no imminent reason for them to plunge now. During the war we estimate that around five million barrels per day were depleted from OECD countries’ stocks, or around 5% of global oil supply. It will take years to replenish these reserves, providing some structural support to oil prices.

For energy firms, the opportunity to capitalise on higher prices has been short-lived. Valuations of major oil and gas firms did not expand materially during the conflict, as investors judged the higher profits to be temporary. With oil prices now seemingly capped below ~USD 100 per barrel, further gains look limited. We see some selective opportunities for oilfield services firms to repair damage caused by conflict in the Middle East, while structural capacity reductions – and Ukrainian attacks on Russian refiners – are supporting margins in the refining sector. But as oil production capacity returns and prices normalise, we see more attractive opportunities in other equity market sectors, namely financials, utilities and healthcare.