What does conflict in the Middle East mean for oil prices and the economy?

Israel launched a retaliatory strike on Iran in the early hours of Friday morning. Oil prices spiked in response, before falling back again. As tensions escalate, what’s next for inflation and the economy?

Flags of Israel and Iran
(Image credit: Manuel Augusto Moreno via Getty Images)

Israel hit Iran’s central province of Isfahan with a missile strike in the early hours of the morning on Friday, 19 April. This caused oil prices to briefly spike, before falling back down again. 

The attack from Israel is the latest in a string of tit-for-tat relations between the two countries. It comes after Iran launched a drone and missile strike on Israel last Saturday. 

There is a long history of tensions between the two countries, but the latest spat was ignited by an airstrike on the Iranian consulate in Syria on 1 April. This is widely believed to have been carried out by Israel, and killed thirteen people. 

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Any further escalation between the two countries could have serious humanitarian and economic consequences. We share our analysis on events in the region, and the implications for oil prices, supply chains, inflation and interest rates.

What’s been going on with oil prices this week?

Iran produces around 4% of the world’s oil, according to the US Energy Information Administration (EIA). This puts it in the top ten producers globally. As such, any conflict involving the country could be highly disruptive to the oil and energy markets.

The price of oil spiked in the aftermath of Israel’s retaliatory strike this morning (19 April), with Brent crude briefly trading above $90 a barrel. However, the oil price has since fallen back as markets adopt a “wait and see” stance. 

It comes after a volatile week for the commodity. Oil prices fell slightly on Monday 15 April after Iran’s drone and missile strike on Israel last weekend. In the days that followed, the oil price fell further on account of evolving economic expectations for the US and China. Brent crude was down 3% on Wednesday. 

“Investors are trying to weigh up the geopolitical risks in the Middle East and the size of US crude inventories on the supply side versus the outlook for the US and Chinese economies on the demand side”, says Victoria Scholar, head of investments at Interactive Investor.

The fact that oil prices fell on Monday, and spiked only briefly this morning, suggests that markets have already priced in some of the geopolitical risk. If you look past the shorter-term volatility, you will see that oil prices have been rising steadily since December to account for rising tensions in the region. 

For now, markets will be watching closely to assess the likelihood of this spiralling into an all-out conflict.

What could push oil prices higher?

Any further escalation of the conflict could cause oil prices to spike – and not just because Iran produces 4% of the world’s oil. It also has significant influence over the Strait of Hormuz, a shipping route which around a fifth of the world’s oil passes through. 

This narrow waterway sits between the Persian Gulf and the Gulf of Oman – and Iran has previously seized ships passing through the strait. 

In July 2019, Iranian forces descended on a Swedish-owned vessel sailing under the British flag. Iranian officials claimed the tanker, named Stena Impero, had broken maritime regulations. The ship and its crew were held for two months. 

More recently, Iran seized a commercial ship with links to Israel on Saturday 13 April, shortly before launching its drone and missile strike.

As well as pushing oil prices up, any disruption in the Strait of Hormuz would add to existing supply chain challenges. We have already experienced several months of Houthi attacks on shipping routes in the Red Sea, and the impact on businesses is starting to be seen. For example, electric car manufacturer Tesla had to close its Berlin factory for two weeks at the end of January as a result of these attacks. 

Central bankers will be keeping an eye on these tensions closely as they continue their battle to control inflation. It was starting to look like the worst of the cost-of-living crisis was over – particularly with the introduction of the new Ofgem energy price cap this April – but current events throw a new spanner in the works. 

What does conflict in the Middle East mean for the economy?

If oil prices spike and supply chains are disrupted, it will be bad news for the global economy. You don’t need a long memory to recall the chain reaction sparked by Russia’s invasion of Ukraine.

Indeed, oil prices are a big driver of inflation. If they rise, your petrol costs and energy bills go up. This doesn’t just affect households – it impacts businesses too. When fuel and energy bills are higher, it costs businesses more to transport their goods and operate their factories. 

Invariably, this also comes back to bite the consumer. When operating costs go up, businesses are forced to pass cost increases onto customers in an attempt to protect their profit margins. If this goes on for long enough, the elastic band snaps as households struggle to pay the new prices and demand falls. Economic growth then slumps. 

What’s more, central banks use interest rates to help keep inflation under control. As we have seen in recent years, higher interest rates can help slow inflation – but they also come with a nasty string of side effects. They make it more expensive for households to borrow money and pay off their mortgages. They also slow economic growth. 

If interest rates are kept high for long enough, the risk is that an economy slips into recession, which invariably results in an increase in the unemployment rate as businesses are forced to make cutbacks. 

For now, this is all hypothetical of course. But central bankers, investors and consumers alike will be watching these events closely over the coming weeks. 

Many were hoping for an interest rate cut from the Bank of England at its June meeting, however markets have now revised these expectations to August or September. 

UK inflation slowed to 3.2% in the twelve months to March, but still came in slightly higher than economists had forecast. UK wage growth is still coming in fairly strong too, and UK GDP growth has been resilient so far this year. These factors will make the Bank of England cautious about cutting rates too soon.  

A further escalation of tensions in the Middle East could compound this further, if it results in higher oil prices or supply chain disruption.

How have stock markets reacted to Israel’s strike on Iran?

“Asian markets bore the brunt of the breaking news of a retaliatory attack on Iran by Israel, also sending Dow futures sharply lower and resulting in further spikes in gold and oil prices”, says Richard Hunter, head of markets at Interactive Investor.

“The generally bearish wave of sentiment following the most recent Middle East attack inevitably washed on to UK shores, with the premier index dipping into the red in opening exchanges”, he added.

The FTSE 100 had been on the cusp of a record-breaking close last Friday (12 April), but has since fallen back. However, it is not just events in the Middle East that have hit the UK market today. 

“Retail sales were unexpectedly flat in March, according to ONS data”, explains Sophie Lund-Yates, lead equity analyst at Hargreaves Lansdown. “This was worse than expected, and included a decline in food store sales”.

Despite this, Hunter highlights that the FTSE 100 remains ahead by  1.4% so far this year. This is a “rare example of its performance overtaking that of the Dow Jones in the US”, he says.

US stock markets have just opened and investors will be watching closely to determine the impact there. Hunter believes that “the escalation will put pressure on the main indices, which were already lining up for a weekly drop”.

Katie Williams
Staff Writer

Katie has a background in investment writing and is interested in everything to do with personal finance and financial news. 

Before joining MoneyWeek, she worked as a content writer at Invesco, a global asset management firm, which she joined as a graduate in 2019. While there, she enjoyed translating complex topics into “easy to understand” stories. 

She studied English at the University of Cambridge and loves reading, writing and going to the theatre.