How much does an Embargo spike Oil Prices?

Taking Iran's oil off the market pushes Brent up by $10 at standard price elasticities

To listen to a lot of commentators, oil prices will drift inexorably higher as oil tanker traffic through the Strait of Hormuz remains substantially encumbered and time goes by. That’s not how markets work. Markets are forward-looking, so - if they expect the Strait to be closed for a significant amount of time - they’ll price that in immediately, instead of pricing it slowly as time passes. In fact, we’ve seen this expectations channel at work recently. On occasions when President Trump has said that the war is nearing its end, oil prices have fallen as markets update their estimate for how long the Strait will remain closed. Conversely, when the President sounds more bellicose, oil prices rise as markets price a longer war.

My point is that markets are reasonably efficient and quick about pricing available information. This includes the possibility of an Iran oil embargo. In recent days, as chatter of an embargo has gone up, the rise in oil prices likely prices rising odds that Iran’s two million barrels per day go offline. This means that an actual embargo - if it gets announced - won’t spike oil prices nearly as much as people fear, because some of that’s already priced in. Using standard price elasticities of demand, shutting in Iran’s oil implies a $10 rise in Brent. My best guess is that an embargo would take us to $120, but not much higher (we’re around $114 as I write this).

Before I start using price elasticities, let me make a big picture observation based on Russia’s 2022 invasion of Ukraine. Russia exports seven million barrels per day versus the 20 million barrels that normally transit the Strait of Hormuz. The current episode is thus three times as important for global oil markets as Russia’s invasion of Ukraine, when markets - in the weeks immediately following the invasion - worried a great deal about Russia being embargoed. As the chart above shows, that’s basically what’s now priced. The blue line shows the rise in Brent since the start of hostilities. This line is up 60 percent. The black line is the rise in Brent on a similar time scale back in 2022. That line is up 20 percent. Markets are pricing the greater order of magnitude of this shock correctly, so it’s far from obvious why Brent should go to $150 or $200.

The table above gives my estimates for where Brent should be based on a reasonable range for price elasticities of demand (vertical axis) and scenarios for oil exports out of the Persian Gulf (horizontal axis). I calculate these based on Brent at $68 per barrel two weeks before the outbreak of war. If you assume an elasticity of 0.15 - the middle of the range I’ve seen people use - it puts Brent around $114 currently assuming that oil out of the Gulf is running at roughly half its normal capacity (i.e. 10 million barrels per day). If you then assume Iran’s two million barrels per day get shut in, that takes Brent up to $123. I consider these kind of numbers upper bounds to what will happen, because they assume permanent supply disruption, when - in reality - all of us know the midterms mean this conflict can’t turn into an open-ended war. Putting all this together, I think an embargo pushes Brent to $120 but not much beyond that.

As I argued recently, the pros of an embargo outweigh the cons. The single biggest con is that it might spike oil prices and I think that risk is overstated in the popular discourse. On the pro side, an embargo will rid us of the mixed messaging towards Iran, where we’re currently at war but turning a blind eye to their oil exports that fund the regime. In my opinion, it’s this mixed messaging that’s at the root of why Russia is still able to fight in Ukraine over four years after the invasion.