These Middle East flashpoints could trigger regional conflict that impacts oil prices

Published Wed, Jan 3 202411:14 AM ESTUpdated Thu, Jan 4 20247:17 AM EST

Oil traders are not taking the risk of escalation in the Middle East seriously enough as the situation in the region deteriorates by the day, according to RBC Capital Markets. There are several key flashpoints where the Israel-Hamas war could escalate into a regional conflict that has a material impact on oil, according to the firm. Those flashpoints are the Red Sea, Lebanon and Iraq, analyst Helima Croft wrote in a note to clients this week. "We still see a clear and present danger that this will become a wider regional conflict," Croft wrote. Crude prices fell Tuesday despite renewed attacks by Houthi militants in the Red Sea over the weekend. The Danish shipping giant Maersk has paused all shipping through the crucial trade chokepoint until further notice due to the deteriorating security situation. The West Texas Intermediate contract for February lost $1.27, or 1.77%, to settle at $70.38 a barrel on Tuesday. The global Brent benchmark shed $1.15, or 1.49%, to settle at $75.89. U.S. crude and the global benchmark rose more than 3% on Wednesday as disruption to an oil field in Libya added to supply concerns from Red Sea tensions. "Given the importance of this region in terms of shipping of crude, production of crude, it's not really reflecting the ratcheting up of tensions," Croft said about prices in an interview with CNBC on Tuesday. Traders got burned by betting on disruptions to oil supply from Russia in the wake of Moscow's invasion of Ukraine that ultimately did not materialize, Croft said. Investors are now questioning how current tensions in the Middle East are different than past crises in the region, she said. "The market is basically saying 'we will wait and see until something happens,'" Croft said. "But it is really getting much more serious every day," she said of tensions in the region. The escalation risk essentially boils down to Iran, according Adi Imsirovic, a veteran oil trader who is now an energy security expert at the Center for Strategic and International Studies. "It all depends on whether there's some sort of contagion where Israel and Iran may get into some sort of conflict and obviously the U.S. would be there on the side of Israel," Imsirovic told CNBC. Red Sea attacks Croft sees growing indications that the U.S. and U.K. are preparing for a more large-scale military operation against the Houthis in Yemen, who are backed by Iran. The U.S. and 12 predominantly Western allies put the Houthis on notice Wednesday. The allies warned the militants that they would "bear the responsibility of the consequences should they continue to threaten lives, the global economy, and free flow of commerce in the region's critical waterways." The Houthis have used missiles and drones to attack ships near the Bab el-Mandeb Strait, which connects the Gulf of Aden to the Red Sea. The attacks have continued despite the U.S. launching a multinational maritime force, Operation Prosperity Guardian, to protect shipping. "Even though the U.S. has built a coalition to protect ships, the shipping companies are not yet sure about it," Steven Schoenfeld, CEO of MarketVector Indexes, told CNBC in an interview Tuesday. "There is a real possibility of kinetic strikes both from the Houthis toward shipping and from the U.S.-led coalition, which was bolstered by Britain over the weekend, against Houthi targets whether those initially be on sea or possibly on land," Schoenfeld said. Tensions escalated Sunday after four small Houthi boats attacked the container ship Maersk Hangzhou. U.S. Navy helicopters responded to a distress call from the vessel, and directly engaged the Houthi militants after taking fire from them. The helicopters sunk three of the boats, killing the crews, according to the U.S. Central Command. The attack came just as major shipping companies such as Maersk started to send vessels through the Red Sea after pressing pause in early December due to the security situation. Maersk stopped shipping through the Red Sea again and is rerouting vessels around the Cape of Good Hope in South Africa. Some 12% of global trade and about 3 million barrels of crude oil pass through the Red Sea per day, according to RBC Capital Markets. Oil shipping through the Red Sea and the Suez Canal has become more important since Russia's invasion of Ukraine as Europe's dependence on crude from the Middle East has grown, according to a JPMorgan note to clients Wednesday. So far, large-scale rerouting of crude tankers around the Cape has not yet materialized, according to the investment bank. Container ships are taking the biggest hit right now. Freight rates on the Asia-Europe route for a 40-foot container have tripled since early December to $4,000 to $5,000 and will likely continue to rise, according to Goldman Sachs in a note to clients Tuesday. Imsirovic said a worst-case scenario in which crude shipments are rerouted around the Cape of Good Hope would create delays but should not fundamentally disrupt oil supplies. The key question is whether Iran will simply stand on the sidelines if the U.S. and U.K. launch a major operation against Tehran's Houthi allies, Croft wrote. Iran deployed a destroyer to the Red Sea after the weekend clashes between the U.S. Navy and the Houthis. While the market is currently focused on the Red Sea, the Strait of Hormuz "is far more consequential for global energy supplies," Croft told clients in her note. An average of 15 million barrels of oil per day transited the strait in 2023, according RBC Capital Markets. "A more fulsome Iranian entry into the war would dramatically increase the threat to regional energy supplies, not only because of the country's energy assets, but also its ability to imperil maritime traffic through the Strait of Hormuz," Croft wrote. Croft pointed to Iran's targeting of tankers in the strait in 2019 after President Donald Trump ratcheted up sanctions against the Islamic Republic. "If you saw any action in the Straits, that would be material for oil prices," she told CNBC on Tuesday. Imsirovic, for his part, said it is unlikely that Iran will intervene directly when Tehran can sit back and cause problems through proxies such as the Houthis, but there is always the risk that messy situations such as that in the Red Sea can spin out of control. Imsirovic also questioned whether there is any appetite in the Biden administration for a war in the Middle East with the presidential election rapidly approaching. Lebanon and Iraq Tensions are also mounting between Israel and Lebanon as Hezbollah, a militant group also aligned with Iran, fires rockets across the southern border. Benny Gantz, a member of Israel's war Cabinet, warned Beirut last week that the Israel Defense Forces would clear Hezbollah out of southern Lebanon if the militants do not withdraw from the area and halt missile attacks. The situation in Lebanon escalated further Tuesday with Hamas blaming Israel for a blast in Beirut that killed the militant group's deputy head, Saleh al-Arouri. Israel so far has declined to comment on the blast. "We believe that the Lebanon/second-front risk remains underappreciated by market participants and that it is one of the main conduits for direct Iranian involvement in the ongoing war," Croft wrote in her note. Hezbollah is more cautious than the Houthis after suffering significant losses in a war with Israel in 2006, according to Croft. Nevertheless, the situation in Lebanon is "extremely precarious" right now and Iran has a much closer relationship with Hezbollah than the Houthis. An expansion of the fighting in Lebanon presents a "clear pathway" to wider regional war as a consequence, Croft wrote. Militias allied with Iran also launched a drone attack last week on a U.S. base in Erbil, Iraq. Three U.S. service members were injured, leaving one of them in critical condition. President Joe Biden responded by launching airstrikes on sites used by the militants in Iraq. An attack that leads to a significant number of U.S. casualties could draw Washington into another round of fighting in Iraq, Croft wrote in her Tuesday note. "We don't know yet really what is the red line for President Biden," Croft told CNBC on Tuesday. Trump had drawn that line at the killing of Americans, and ordered the assassination of Iranian Gen. Qasem Soleimani in January 2020 in response. The problem is that the U.S. may not really have much control over events, Croft said. "That's why we say watch the situation in Lebanon because the Israelis have said that they are not going to stand for Hezbollah staying on that border," she said.