How high will oil prices go?

The 60 percent rise in Brent prices the Strait of Hormuz running at half its capacity

The Brent oil price yesterday rose to $110 as the conflict in the Persian Gulf escalated. Factoring in that oil prices started rising well before hostilities broke out on February 28 - markets started pricing in a war risk premium about two weeks before - Brent is now up around 60 percent as a result of this conflict.

At times of high uncertainty, it’s tempting to think things can only get worse. There’s certainly plenty of forecasters who see Brent going to $150 or even $200. The purpose of this post is to disentangle what’s priced into Brent at $110, i.e. what does this tell us about what markets assume for supply disruptions through the Strait of Hormuz.

I’m going to use a standard approach Ben Harris and I used recently to disentangle what’s priced into oil at $110. This suggests markets now price a scenario where half of all oil exports out of the Persian Gulf are permanently disrupted. Saudi Arabia’s oil exports are back up to half of what they were before the war (seven million barrels per day). Factoring in Iran’s exports (two million barrels per day) and a gradual recovery in other traffic, we’re already close to ten million barrels per day, which is half of what went through the Strait before this conflict. That makes $150 or $200 a stretch, before you even consider the growing possibility of a Trump TACO.

Back in December 2022, Catherine Wolfram, Simon Johnson and LUKASZ RACHEL published a paper explaining the G7 oil price cap on Russia. Much of the rationale for the price cap was that a full embargo would spike global oil prices, plunging the world into recession. They wrote: “if the short-run price elasticity of demand is 0.10 and the world is hit with a drop in Russian oil exports worth two percent of global supply, then the oil price must rise 20 percent (0.02/0.1*100) to reduce demand such that the oil market clears.”

In practice, there’s lots of uncertainty about the elasticity in question. Caldara et al. (2019) put it at 0.14, while Helmi et al. (2024) have an estimate of 0.18. The chart above uses elasticities in the range from 0.10 to 0.20 on the axis closest to the reader. I then assume different scenarios for tanker disruption through the Strait of Hormuz on the axis going away from the reader. 20 million barrels per day mean no disruption, while 2 million barrels per day mean almost complete disruption (except for Iranian oil). The vertical axis shows the oil price rise implied by various combinations of these two.

An elasticity of 0.15, which is what Ben and I work with, implies a 60 to 70 percent rise in oil prices for capacity out of the Persian Gulf being cut in half. I’ve indicated this in the chart above with a red dot. Brent going to $200 would be a 190 percent rise from before the war, which the chart doesn’t quite reach even under the most extreme assumptions. My conclusion out of all this is that Brent - at current levels - is pricing very material supply disruption, so there’s limited scope for prices to go higher.

All this nerding out ignores the really important questions. As oil prices rise, the risk of a Trump TACO goes up. As the US and Israel continue to pound Iran, the risk that the regime falls must also be rising. There’s lots of catalysts for prices to fall, which gets forgotten amid the “fog of war.”

My last comment is that - given how much oil prices have now risen - I think the optimal strategy for the US is to embargo Iranian oil. A blockade of Iran’s ports will starve the regime of the hard currency inflows it needs to keep going and could well be more effective at getting the Strait of Hormuz opened up than any alternative.