Escalating tensions between major oil producer Saudi Arabia and Iran sent oil prices sharply higher in the first trading day of 2016 on the prospect of supply disruption.
Benchmark U.S. WTI light sweet crude was up 1.9 percent at $37.76 a barrel early afternoon in Asia, after jumping as much as 3.4 percent from the last day of trade in 2015, while Brent crude was up 2.3 percent at $38.12 a barrel after spiking 2.4 percent over the same period.
The kneejerk reaction came after Saudi Arabia cut ties with Iran, after its embassy in Tehran was attacked by Iranians protesting the Saudis' execution of a prominent Shiite cleric.
Heightened tensions between the two OPEC producers troubles investors because most oil Saudi oil production comes from its Eastern Province, which is dominated by Shiites, Bernstein's senior oil and gas analyst Neil Beveridge explained.
"This is the area that could potentially suffer if there is an escalation in tensions between Saudi Arabia and Iran," he told CNBC Squawk Box on Monday.
Tensions, but not much risk premium
Oil prices were battered last year, sliding over 40 percent on the back of a supply glut.
But despite gains in oil prices on Monday, the risk premium for current Middle Eastern tensions were "incredibly low," said Juerg Kiener, managing director and chief investment officer of Swiss Asia Capital in Singapore,
"I've never seen escalations, geopolitical (tensions) in the Middle East like we see them today and the oil price has hardly moved from the bottom," Kiener told CNBC's Capital Connection.
At around $38 a barrel, oil prices are still at multi-year lows, after OPEC refused to lower its 30-million-barrel-a-day production ceiling at its production meeting in December.
Fears about supply dominate
Although there are fears of even heavier output in 2016, with Iran expected to resume exports following the lifting of U.S. sanctions, this risk is a longer-term concern. More current geopolitical concerns and their potential impact on supply are dominating price action, as global spare crude oil capacity is "limited" at 2 million barrels a day, said Bernstein's Beveridge.
Saudi Arabia produces about 10 million barrels of oil a day, while Iran's output is about 3 million barrels a day, so any potential supply or shipping disruption would have a significant impact on the market, Beveridge added.
Supply interruption in Saudi Arabia and Iran could come at the same time as slowing production at other producers. While the U.S. is exporting crude for the first time in 40 years, production is likely to decline due to a significant reduction in capital expenditure amid the oil price rout, he said.
Another non-OPEC supplier, Russia, will also see limited on-year output growth due to capex cuts. "We are probably past the peak in terms of non-OPEC supply growth," Beveridge said.
Oil consumption, meanwhile, is likely to be strong this year, after most economies posted 2 percent growth in demand in 2015.
Demand strength amid these expected supply cuts is likely to prompt the oil markets to rebalance in the second half of the year, particularly as U.S. production continues to be slow, said Paradigm Securities' head of resources, Barry Dawes.
A Saudi Arabian complication
But IG market strategist Evans Lucas warned that further complication and volatility could come from Saudi Arabia, which could possibly increase production to counter any fallout from the conflict with Iran, which means that $20 a barrel oil remains "a real possibility," particularly as other non-OPEC nations power ahead with production.
Meanwhile, Kamran Bokhari, author of "Political Islam in the Age of Democratization," told CNBC that at the same time, the row between Saudi Arabia and Iran would likely become more heated.
"Both sides are gearing up for escalation; we are going to see more and more escalation as we move forward," said Bokhari, who is also a lecturer at the University of Ottawa's Security and Policy Institute.
The spat may even spill over into Lebanon, Yemen or Iraq, giving leverage to militant group Islamic State to exploit inter-sectarian tensions in the Middle East, he added.
"The West now has a huge dilemma in choosing a side to 'support.' This is a political conundrum of epic proportions and one that will push governments ethically and economically," IG's Evans wrote in a Monday note.