The oil market faced a rude awakening this week after Iran launched a large-scale ballistic missile attack against Israel, briefly sending crude prices more than 5% higher Tuesday after a period of sleepy trading.
For months now, traders have largely dismissed the risk of a supply disruption in the Middle East. Instead, bearish sentiment swept the market in September as investors increasingly fear a surplus next year due to softening demand in China and increased production from OPEC+.
The expanding war in the Middle East, however, has reached a new boiling point as Israel has vowed a "painful" response to Iran's attack. The government of Prime Minister Benjamin Netanyahu could take aim at the Islamic Republic's oil infrastructure in retaliation, geopolitical and crude market analysts say.
"There has been a lot of complacency about this war," Helima Croft, head of global commodity strategy at RBC Capital Markets, said Tuesday on CNBC's "The Exchange" shortly after the attack. "We do need to think about a scenario where Iranian oil supplies are at risk."
Israel could also take aim at Iran's nuclear facilities, but those buildings are hardened, making them difficult to destroy, said retired U.S. Army Col. Jack Jacobs. A strike on those facilities could trigger an even larger ballistic missile attack by Iran that would be difficult to defend against, he said.
"What is really on the table now and is more likely is an attack on oil facilities," Jacobs said Wednesday morning on CNBC's "Squawk Box."
OPEC member Iran is producing at a five-year high of more than 3 million barrels per day, Croft said. U.S. intelligence in the past has highlighted the potential risk to Iran's Kharg Island oil terminals, through which 90% of the country's crude exports pass, according to a Tuesday note from RBC Capital Markets.
"The next turn in this retaliation spiral may very well involve oil – via the degrading of Iran's oil capacity or Iran's proxies attacking oil and gas shipping from the Persian Gulf," Piper Sandler analysts told clients in a Wednesday research note.
The impact on the oil market would depend on the damage done to Iranian crude exports and how the situation escalates from there, said Bob McNally, president of Rapidan Energy. If Iran's oil exports of around 1.8 million bpd were taken offline, prices would likely jump by at least $5 per barrel, McNally said.
Iran, in turn, would likely retaliate by threatening the 13 million bpd of crude and 5 million bpd of products that are produced in and flow through the Persian Gulf, McNally said. An escalation on this scale could send oil prices higher in increments of $10 per barrel, the analyst said.
"These are dangerous times for oil markets at the moment," Andy Critchlow, EMEA head of news at S&P Global Commodity Insights, told CNBC's "Street Signs Europe" on Wednesday. "It's hard for anyone in the market to really gauge the direction when you look at the amount of geopolitical risk that is out there."
OPEC, however, has 5.6 million bpd of spare capacity that can be brought back to the market with Saudi Arabia keen to return as much of its oil back to the market as possible, Critchlow said.
"Any disruption to Iranian supplies to the international market I think could be made up by spare OPEC capacity and it's idled oil at the moment," the analyst said.
McNally, however, said this oil won't mean much if there is a major disruption in the Persian Gulf. "Spare capacity won't help because it's mostly bottled up inside the Strait of Hormuz," the analyst said.
