· Tension in the region due to Hamas’s unexpected strike on Israel is causing Oil prices to spike.

· Ripple effect could be higher future inflation expectations & lower equity valuations.

The importance of the Middle East for the world is quite significant, as a third of the globe’s oil production comes from that region.

Following the Hamas surprise strike on Israel over the weekend, the death toll on both sides climbed in the low thousands. The US said it is sending warships to the region as the conflict is heading into a 4 ^th day, causing oil prices to reverse their recent decline as war-risk premium grips the market.

In late September, Brent was on track to hit the $100 a barrel mark as cuts from powerhouses Saudi Arabia and Russia created a tighter oil market. However, the climb abruptly reversed last week, with prices suffering a steep decline, sparked by fears over weakening demand and markets bracing for a prolonged period of higher interest rates.

El-Erian says, «If this expands and brings in other parties, the outlook is for an even weaker global economy and more inflationary pressure. The markets are going to find it harder to deal with that.»

The heightened geopolitical risk might quickly escalate if Israel blames Iran, as the latter is a major oil producer and supporter of Hamas. Any retaliation against Tehran may endanger the passage of vessels through the Strait of Hormuz, a vital conduit Iran has previously threatened to close.

The strait, which is between Oman and Iran, is considered the world’s most important oil transit chokepoint, and more importantly, 40% of world exports go through the Strait of Hormuz; hence, a conflict between the two parties can easily lead to a meaningful jump in oil prices.

The last time a major conflict between Israel and the Arab states occurred, in the 1970s Oil Crisis, saw the benchmark WTI oil price shoot up around 3x – from about $3 per barrel (pb) to around $10 pb.

In today’s world, if you extrapolate a similar move, that will translate into oil tripling to over $250 a barrel, which is quite unlikely but will send inflation soaring through the roof.

Lately, there were two consecutive positive inflation prints on the US CPI, showing inflation climbing higher once again on the back of oil prices climbing nearly 40% since June.

Israel might not be a significant player in the worldwide oil supply. Nevertheless, the conflict might put Iran and the USA at odds. Iran has emerged as a critical supplier of additional crude oil, helping to ease markets that were becoming constrained due to supply cuts from Saudi Arabia and Russia. Any US sanctions on Tehran might limit those deliveries, which has the potential to cause oil markets to keep rising.

Equities have been holding for now, but any geopolitical escalation will put downward pressure on them.

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