LONDON: An escalation of the diplomatic dispute between Iran and Saudi Arabia looks like a black swan event for the oil market: hard to predict, but potentially huge in its effects. Open conflict between the two Middle East powers would threaten nearly one-fifth of world oil supplies, shipped daily through the Strait of Hormuz.

Relations between the two Middle Eastern countries were already at boiling point before Saudi executed the cleric and outspoken critic of the kingdom’s royal family Sheikh Nimr al-Nimr. The two countries are fighting proxy wars in Syria and Yemen, and Saudi’s strategy of pushing down the oil price through increased production counts producer Iran among its unhappy victims. The severing of diplomatic ties following the storming of the Saudi embassy in Tehran on Jan 3 has raised the chances of open conflict between the two states.

Were a war to break out between Saudi and Iran, Tehran’s most obvious way of hurting its rival would be to cut off oil exports from the Gulf passing through the Strait of Hormuz. Record global stockpiles would start to drain away if the flow of tankers carrying about 17 million barrels per day of crude through the 21-mile wide channel — which separates Iran from the Arabian Peninsula — were interrupted by armed conflict in the Gulf.

The kingdom’s close allies in the Gulf, who also oppose Iran extending its influence in the region, would also be squeezed.

Both sides would lose, but Iran less so. According to the US Department of Energy, Saudi Arabia could divert just under a third of its 7.2m bpd of crude exports away from the Gulf chokepoint. However, the loss of exports would still severely test Saudi Arabia’s economy. By contrast, since it is restrained by international sanctions, which could be lifted this year, Iran is exporting just 1.4m bpd through Hormuz. Iran has already been forced to adjust to years of lost oil income.

Where does that leave the oil market? While the conflict between the two states remains indirect, it means more of the same low prices. But any escalation still has the potential to send prices rocketing back towards $100 per barrel, putting the risk emphatically on the upside.

Published in Dawn, January 5th, 2016

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