Oil investors are underestimating the seriousness of the Saudi Arabia - Iran diplomatic skirmish

On Saturday, Saudi Arabia executed a prominent Shi’ite cleric, Sheikh Nimr al-Nimr.

He was considered a terrorist by the Saudis, “but hailed in Iran as a champion of the rights of Saudi Arabia’s marginalized Shi’ite minority.”

So, this understandably did not sit well with Iran.

Iran’s Supreme Leader Ali Khamenei warned that the Saudis would face “divine vengeance” for their actions, likening them to ISIS, and Iranian protesters ransacked and set fire to the Saudi embassy in Tehran in retaliation.

Shortly after that attack, Saudi Arabia announced that it will cut all diplomatic ties with Iran, adding that Iranian diplomats have 48 hours to leave the country.

In short, tensions are high between the two big Middle East powers.

Oil prices have been very volatile in the aftermath of the weekend’s turmoil. Prices spiked overnight, then fell back dramatically in early-morning trade in London on Monday, and then bounced back again. WTI crude is currently up around 2.05% at $37.80, while Brent is up 2.90% at $38.36.

But the potential long-term impact to oil prices is also interesting to consider.

In a recent note to clients, Macquarie Research’s Vikas Dwivedi argues that the Iran-Saudi disagreement could prove to be bullish for oil due
to the “implications for longer-term strife and [the] possibility of war.

“The escalation of Saudi/Iran or Sunni/Shia tensions continues to be underappreciated by oil investors,” he argues. “While supply growth continues to overwhelm demand in the near term, the vast majority of our 2016 supply growth comes from three countries, all located in the Middle East: Saudi Arabia, Iraq, and Iran. Any war between these nations, especially on Saudi or Iranian soil, represents significant upside to oil prices, even if production itself is not negatively impacted.”

Going from a diplomatic skirmish to an all-out war sounds like a huge jump. But Dwivedi notes that wars in the past have been sparked by “relatively small catalysts, which in hindsight, enabled broader, already prevalent antagonistic attitudes to boil over into major and often times violent events.”

“Where tensions already exist, innocuous events may cause seemingly outsized events,” he concludes.

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